132672 FINANCIAL ACCOUNTING MANUAL 2021 V5

Financial Accounting

Course Manual

Professional, Practical, Provenwww.AccountingTechniciansIreland.ie

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Table of Contents

FOREWORD .............................................................................................................xiii

SYLLABUS: FINANCIAL ACCOUNTING ................................................................xix

CHAPTER 1: INTRODUCTION TO ACCOUNTING ....................................................1

1.1 ACCOUNTING ............................................................................................................................2

1.2 TYPES OF ACCOUNTING .........................................................................................................2

1.3 USERS OF FINANCIAL ACCOUNTING INFORMATION ...........................................................3

1.3.1 Investors .......................................................................................................................3

1.3.2 Lenders .........................................................................................................................4

1.3.3 Suppliers .......................................................................................................................4

1.3.4 Customers .....................................................................................................................4

1.3.5 Competitors ...................................................................................................................4

1.3.6 Employees ....................................................................................................................5

1.3.7 Government ..................................................................................................................5

1.3.8 Analysts ........................................................................................................................5

1.3.9 Public at large ...............................................................................................................5

1.4 FINANCIAL STATEMENTS .........................................................................................................6

1.4.1 Statementoffinancialposition ......................................................................................6

1.4.2 Income statement .........................................................................................................6

1.4.3 Statementofcashflows ................................................................................................7

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1.4.4 Statement of changes in equity .....................................................................................7

1.4.5 Notestothefinancialstatements ..................................................................................7

1.5 ELEMENTS OF FINANCIAL STATEMENTS ...............................................................................8

1.5.1 Assets ...........................................................................................................................8

1.5.2 Liabilities .......................................................................................................................8

1.5.3 Owner equity .................................................................................................................8

1.5.4 Income ..........................................................................................................................8

1.5.5 Expenses ......................................................................................................................8

1.6 QUALITIES OF USEFUL INFORMATION...................................................................................8

1.6.1 Understandability ..........................................................................................................9

1.6.2 Relevance .....................................................................................................................9

1.6.3 Materiality ......................................................................................................................9

1.6.4 Reliability .......................................................................................................................9

1.6.5 Substance over form .....................................................................................................9

1.6.6 Prudence .......................................................................................................................9

1.6.7 Completeness .............................................................................................................10

1.6.8 Comparability ..............................................................................................................10

1.6.9 Timeliness ...................................................................................................................10

1.6.10 Balancebetweencostandbenefit ..............................................................................10

1.7 SUMMARY AND CONCLUSIONS ............................................................................................10

CHAPTER 2: DOUBLE-ENTRY BOOKKEEPING .....................................................13

2.1 THE ACCOUNTING EQUATION ...............................................................................................14

2.2 DOUBLE-ENTRY BOOKKEEPING ...........................................................................................16

2.2.1 Rules of Double-Entry Bookkeeping ...........................................................................16

2.2.2 ApplyingDouble-EntryBookkeepingrulestospecificAsset,LiabilityandEquityAccounts .....................................................................................................................17

2.2.3 Double-Entry Bookkeeping Rules for Income and Expenses .....................................17

2.3 ACCOUNTING FOR CASH TRANSACTIONS .........................................................................19

2.4 ACCOUNTING FOR CREDIT TRANSACTIONS ......................................................................21

2.5 ACCOUNTING FOR PROMPT PAYMENT SETTLEMENT DISCOUNTS ................................23

2.6 ACCOUNTING FOR CAPITAL EXPENDITURE .......................................................................24

2.7 LEDGER ACCOUNTS ..............................................................................................................26

2.8 BALANCING OFF LEDGER ACCOUNTS ................................................................................31

2.9 EXTRACTING A TRIAL BALANCE ...........................................................................................33

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2.10 SUMMARY OF DOUBLE-ENTRY BOOKKEEPING FOR COMMON TRANSACTIONS ..........35


CHAPTER 3: INTRODUCTION TO PREPARATION OF FINANCIAL STATEMENTS OF A SOLE TRADER ........................................................................37

3.1 INTRODUCTION TO PREPARATION OF FINANCIAL STATEMENTS ....................................38

3.2 INCOME STATEMENT – DOUBLE-ENTRY BOOKKEEPING ..................................................39

3.3 STATEMENT OF FINANCIAL POSITION – A LIST OF BALANCES ........................................45

3.4 FORMATTED FINANCIAL STATEMENTS ................................................................................47

3.4.1 Formatted Income Statement .....................................................................................47

3.4.2 Formatted Statement of Financial Position .................................................................49

3.4.3 Formatted Financial Statements for JoeCo ................................................................51


CHAPTER 4: INVENTORIES .....................................................................................55

4.1 THE NATURE OF INVENTORIES ............................................................................................56

4.2 VALUATION OF INVENTORIES ...............................................................................................56

4.2.1 Cost .............................................................................................................................56

4.2.2 Selling Price less Costs to Complete and Sell ............................................................57

4.3 ACCOUNTING FOR INVENTORIES ........................................................................................59

4.3.1 Closing Inventories .....................................................................................................59

4.3.2 Opening inventories ....................................................................................................62

4.4 EFFECT OF CLOSING INVENTORIES ON FINANCIAL STATEMENTS .................................63


CHAPTER 5: IRRECOVERABLE DEBTS .................................................................67

5.1 INTRODUCTION TO IRRECOVERABLE DEBTS ....................................................................68

5.2 AGED ANALYSIS OF TRADE RECEIVABLES .........................................................................68

5.3 ACCOUNTING FOR IRRECOVERABLE DEBTS .....................................................................69

5.4 IRRECOVERABLE DEBTS RECOVERED ...............................................................................71

5.5 EFFECT OF IRRECOVERABLE DEBTS ON FINANCIAL STATEMENTS ...............................73


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CHAPTER 6: ACCRUALS AND PREPAYMENTS ....................................................77

6.1 THE ACCRUALS CONCEPT ....................................................................................................78

6.2 ACCRUED EXPENDITURE ......................................................................................................78

6.2.1 Closing Accruals for Expenses ...................................................................................78

6.2.2 Opening Accruals for Expenses ..................................................................................83

6.3 PREPAID EXPENDITURE ........................................................................................................85

6.3.1 Closing Prepayments of Expenses .............................................................................85

6.3.2 Opening Prepayments of Expenses ...........................................................................88

6.4 ACCRUED INCOME .................................................................................................................90

6.4.1 Closing Accrued Income .............................................................................................90

6.4.2 Opening Accrued Income ............................................................................................91

6.5 PREPAID INCOME ...................................................................................................................94

6.5.1 Closing Prepaid Income ..............................................................................................94

6.5.2 Opening Prepaid Income ............................................................................................95

6.6 EFFECT OF ACCRUALS AND PREPAYMENTS ON FINANCIAL STATEMENTS ...................96

6.7 SUMMARY AND CONCLUSIONS ..........................................................................................100

CHAPTER 7: NON-CURRENT ASSETS AND DEPRECIATION ............................101

7.1 CAPITAL EXPENDITURE AND REVENUE EXPENDITURE ..................................................102

7.2 NON-CURRENT ASSETS AND CURRENT ASSETS .............................................................103

7.3 NON-CURRENT ASSET REGISTERS ...................................................................................103

7.4 ACCOUNTING FOR NON-CURRENT ASSETS .....................................................................104

7.5 DEPRECIATION ......................................................................................................................104

7.5.1 Rationale for depreciation .........................................................................................104

7.5.2 Estimating the Amount of a Depreciation Expense ...................................................105

7.5.3 Straight-Line Method of Depreciation .......................................................................105

7.5.4 Reducing Balance Method of Depreciation ...............................................................107

7.5.5 Consistency of Calculation and Application of Depreciation ..................................... 111

7.6 DISPOSAL OF A NON-CURRENT ASSET ............................................................................. 112

7.6.1 Disposal for Cash Proceeds ..................................................................................... 112

7.6.2 Disposal by means of a Part-Exchange/Trade-In ..................................................... 114

7.7 EFFECT OF DEPRECIATION ON FINANCIAL STATEMENTS .............................................. 117


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CHAPTER 8: PAYROLL ..........................................................................................123

8.1 ACCOUNTING FOR PAYROLL (REPUBLIC OF IRELAND) ...................................................124

8.2 ACCOUNTING FOR PAYROLL (NORTHERN IRELAND) ......................................................126


CHAPTER 9: BOOKS OF PRIME ENTRY ..............................................................129

9.1 INTRODUCTION .....................................................................................................................130

9.2 BOOKS OF PRIME ENTRY ....................................................................................................130

9.2.1 The Journal ...............................................................................................................130

9.2.2 Sales Day Book ........................................................................................................131

9.2.3 Sales Returns Day Book ...........................................................................................132

9.2.4 Purchases Day Book ...............................................................................................133

9.2.5 Purchases Returns Day Book ..................................................................................133

9.2.6 Cash Receipts Day Book ..........................................................................................134

9.2.7 Cheque Payments Day Book ....................................................................................135

9.2.8 Books of Prime Entry – Conclusions .........................................................................136

9.3 THE PETTY CASH IMPREST SYSTEM .................................................................................137


CHAPTER 10: CONTROL ACCOUNTS AND CONTROL ACCOUNT RECONCILIATIONS ................................................................................................139

10.1 INTRODUCTION .....................................................................................................................140

10.2 CONTROL ACCOUNTS ..........................................................................................................140

10.2.1 Trade Receivables Control Account ..........................................................................140

10.2.2 Trade Payables Control Account...............................................................................143

10.3 SUBLEDGER ACCOUNTS .....................................................................................................146

10.3.1 Trade Receivables Subledger ...................................................................................146

10.3.2 Trade Payables Subledger........................................................................................149

10.3.3 Supplier Statements ..................................................................................................151

10.4 PURPOSE OF CONTROL ACCOUNTS .................................................................................152

10.5 CONTROL ACCOUNT RECONCILIATIONS ...........................................................................152


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CHAPTER 11: VALUE ADDED TAXATION .............................................................157

11.1 VALUE ADDED TAX (VAT) ......................................................................................................158

11.2 ACCOUNTING FOR VAT ........................................................................................................159

11.2.1 VAT on Credit Sales ..................................................................................................159

11.2.2 VAT on Sales Returns ...............................................................................................160

11.2.3 VAT on Cash Sales ...................................................................................................161

11.2.4 VAT on Credit Purchases ..........................................................................................162

11.2.5 VAT on Purchases Returns .......................................................................................163

11.2.6 VAT on Other Expenses ............................................................................................163

11.2.7 VAT consequence of an Irrecoverable Debt ..............................................................164

11.2.8 The VAT Ledger Account ..........................................................................................165


CHAPTER 12: BANK RECONCILIATIONS ............................................................167

12.1 INTRODUCTION .....................................................................................................................168

12.2 NATURE AND PURPOSE OF A ‘BANK RECONCILIATION’ ..................................................168

12.3 BASIC EXAMPLES OF A BANK RECONCILIATION PROCESS ...........................................169

12.4 COMPREHENSIVE EXAMPLES OF A BANK RECONCILIATION PROCESS .......................175


CHAPTER 13: TYPES OF BUSINESS ENTITY AND THE REGULATORY FRAMEWORK .........................................................................................................185

13.1 INTRODUCTION .....................................................................................................................186

13.2 TYPES OF BUSINESS ENTITY ..............................................................................................186

13.2.1 Sole trader ................................................................................................................186

13.2.2 Partnership ................................................................................................................187

13.2.3 Limited Company ......................................................................................................188

13.2.4 ‘Notforprofit’organisations ......................................................................................190

13.2.5 Conclusion on types of business entity .....................................................................190

13.3 THE FINANCIAL ACCOUNTING REGULATORY FRAMEWORK ..........................................190

13.3.1 European Law ...........................................................................................................190

13.3.2 Companies Acts ........................................................................................................191

13.3.3 Financial Reporting Standards ..................................................................................191

13.4 THE CONCEPT OF ‘TRUE AND FAIR’ ...................................................................................191

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13.5 AUDITING ...............................................................................................................................192

13.6 THE ACCOUNTANT’S ROLE IN ORGANISATIONS ..............................................................193

13.7 PROFESSIONAL ETHICS IN ACCOUNTING .........................................................................193

13.7.1 Professional Code of Ethics ......................................................................................193

13.7.2 Ethical Issues in Financial Accounting ......................................................................194


13.9 APPENDIX TO CHAPTER 13 .................................................................................................195

CHAPTER 14: PREPARATION OF FINANCIAL STATEMENTS OF A SOLE TRADER ...................................................................................................................197

14.1 INTRODUCTION .....................................................................................................................198

14.2 STANDARD JOURNALS FOR YEAR END ADJUSTMENTS .................................................200

14.2.1 Inventories ................................................................................................................200

14.2.2 Irrecoverable debts ...................................................................................................200

14.2.3 Accruals and Prepayments .......................................................................................200

14.2.4 Depreciation of a Non-current Asset .........................................................................201

14.2.5 Disposal of a Non-current Asset ...............................................................................201

14.2.6 Reconciliations ..........................................................................................................202

14.3 PRO-FORMA FINANCIAL STATEMENTS ..............................................................................203

14.3.1 Income Statement .....................................................................................................203

14.3.2 Statement of Financial Position ................................................................................204

14.4 PREPARATION OF THE FINANCIAL STATEMENTS OF A SOLE TRADER .........................205


CHAPTER 15: PREPARATION OF FINANCIAL STATEMENTS OF A PARTNERSHIP ........................................................................................................217

15.1 INTRODUCTION .....................................................................................................................218

15.2 THE ACCOUNTING CONSEQUENCES OF A PARTNERSHIP BUSINESS STRUCTURE ...219

15.2.1 Capital Accounts and Current Accounts ....................................................................219

15.2.2 The Appropriation Account ........................................................................................220

15.2.3 AccountingJournalstoRecordPartnerSalariesandProfitAppropriation ................221

15.3 STATEMENT OF FINANCIAL POSITION OF A PARTNERSHIP ............................................225


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CHAPTER 16: PREPARATION OF FINANCIAL STATEMENTS OF A LIMITED COMPANY ...............................................................................................................237

16.1 INTRODUCTION .....................................................................................................................238

16.2 THE FINANCIAL STATEMENTS OF A LIMITED COMPANY ..................................................239

16.2.1 The Income Statement ..............................................................................................239

16.2.2 The Statement of Financial Position .........................................................................241

16.3 THE EQUITY SECTION OF A STATEMENT OF FINANCIAL POSITION ...............................242

16.3.1 Ordinary Share Capital .............................................................................................242

16.3.2 Share Premium .........................................................................................................242

16.3.3 Retained Earnings ....................................................................................................243

16.3.4 Dividends ..................................................................................................................244

16.4 RAISING LONG-TERM FINANCE BY MEANS OF A DEBT INSTRUMENT ..........................245

16.5 PREPARATION OF FINANCIAL STATEMENTS FROM TRIAL BALANCE ............................247


CHAPTER 17: CORRECTION OF ERRORS AND USE OF SUSPENSE ACCOUNTS .............................................................................................................257

17.1 INTRODUCTION .....................................................................................................................258

17.2 IDENTIFICATION OF POSSIBLE ERRORS OR OMISSIONS ...............................................258

17.2.1 Trial Balance .............................................................................................................258

17.2.2 Bank Account Reconciliation .....................................................................................258

17.2.3 Receivables and Payables Control Account Reconciliations ....................................259

17.2.4 Review of Financial Statements ................................................................................259

17.2.5 Independent Audit .....................................................................................................259

17.3 APPROACH TO CORRECTION OF ERRORS AND OMISSIONS .........................................259

17.3.1 Errors that Do Not Cause Trial Balance Totals to Disagree ......................................260

17.3.2 Errors that Cause Trial Balance Totals to Disagree ..................................................266

17.4 IDENTIFICATION OF ERRORS AND OMISSIONS ARISING FROM CONTROL ACCOUNT RECONCILIATIONS .............................................................................................272

17.5 IDENTIFICATION OF ERRORS AND OMISSIONS ARISING FROM BANK ACCOUNT RECONCILIATIONS ................................................................................................................273

17.6 THE IMPACT OF CORRECTING ERRORS AND OMISSIONS ON PROFIT OR LOSS ........274


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CHAPTER 18: ACCOUNTING FOR ‘NOT FOR PROFIT’ ORGANISATIONS ........277

18.1 ‘NOT FOR PROFIT’ ORGANISATIONS ..................................................................................278

18.2 PRINCIPLES THAT UNDERPIN ‘NOT FOR PROFIT’ ACCOUNTING ...................................278

18.2.1 The Accounting Equation Applies .............................................................................278

18.2.2 Income and Expenditure Account ............................................................................278

18.2.3 Accumulated Fund Statement ..................................................................................280

18.2.4 Membership Subscriptions .......................................................................................281

18.2.5 Receipts and Payments Account .............................................................................283

18.3 PREPARATION OF FINANCIAL STATEMENTS OF A ‘NOT FOR PROFIT’ ORGANISATION .....................................................................................................................284


BIBLIOGRAPHY ......................................................................................................289

INDEX.......................................................................................................................291

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FOREWORD

Foreword

This text has been developed by Accounting Technicians Ireland for use by students participating in our programme of study and preparing for our examinations based on the syllabus published for the Academic Year 2021-2022.

While every effort is made to ensure that the information outlined in this text is accurate, Accounting Technicians Ireland cannot accept the responsibility for lack of, or perceived lack of, information contained herein.

Thetextisintendedtobeasufficientlydetailedsynopsisofthecurrentsyllabusmaterial(andknowledgelevel required thereof) in relation to this module.

Students should take particular note of the weighting attached to this module, as clearly outlined in the syllabus. It is on the basis of this weighting that students should prepare their own timetable for study.

Questions and Solutions related to the topics for this module can be found on MyRevision. These questions are part of a large database of questions that students (and also lecturers) can access online for this subject. These questions (and suggested solutions) are available through your “TouchPoint” portal in the MyRevision area.

We recommend that students refer to MyRevision having completed each chapter or a section of this module. MyRevision provides the student with access to “self-test” questions and practice exam type questions online to support learning.

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Referencing

For the purposes of consistency, all references to “he” or “she” will be referred to as “he” in this publication. No other implication whatsoever is implied from this policy.

For the purposes of presentation, all references to “euro” or “sterling” will be referred to as “euro” in this publication. No other implication whatsoever is implied from this policy.

Copyright

This text is issued by Accounting Technicians Ireland to students taking its examinations. It may not be used in whole, or in part, for any course of study and/or examination of any other body whatsoever without prior permission in writing from Accounting Technicians Ireland. This publication, or any part thereof, may not be made available in any library, and it may not be reproduced, in whole or in part, stored in a retrieval system or transmitted in any form or by any means – photocopying, electronic, electrostatic, magnetic, pdf, mechanical, recording or otherwise, without prior permission in writing from Accounting Technicians Ireland, 47-49 Pearse Street, Dublin 2.

Acknowledgements

This edition was authored by:

Dr Barry Smith. Barry is a tutor in Financial Accounting for Accounting Technicians Ireland and is the primary developer of the MyRevision online educational resource.

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How to Access your Knowledge Point Online Tutorials

STEP 1: Login to Touchpoint

To login, simply enter in your username, password & pin, then click “Login”.

USERNAME: This is your Registration Number. If you have lost your Registration No., please contact us directly.

PASSWORD: This is your Date-of-Birth in full without Spaces or hyphens. For example if your Date-of-Birth is 1st Jan 1970 then your password is 01011970.

PIN: The pin is 123456 please enter the relevant number in the highlighted boxes with the number shown.

STEP 2: In the My Learning Resources, select KP Library, click on View All.

Step 3: Select the “year” that you want to see STEP 4: Click the “Play” icon to watch a Tutorial, or click the “Notes” icon to download the notes.

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Online Revision Questions and Solutions

Practise questions and solutions are available online through your TouchPoint portal. You can access themthroughthe‘MyRevision’sectionoftheportal.Youcanalsofindrecentpastexampapersandsample papers in the MyRevision section of your student portal.

STEP 1: Log in to TouchPoint

STEP 2 Select ‘View All’ in the MyRevision section.

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STEP 3: Select a module

STEP 4: Search for content by keyword and/or by topic. Then select ‘Proceed’.

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STEP 5: Makefurtherrefinementstothesearchifrequired.Thenselect‘CreateQuiz’.

STEP 6: Taketheon-screenquiz(ordownloadlongerquestionsasPDFsforprinting)

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SYLLABUS: FINANCIAL ACCOUNTING

Module: Financial Accounting

Mandatory Module

SYLLABUS 2021-2022

Syllabus : Mandatory Module

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Subject Status Mandatory

Module Pass Mark: 50%

Learning Modes: Direct Lectures, Workshops, Tutorials, Self- Directed Learning

Pre-requisite: Programme Entry Requirements

OVERALL MODULE AIM

The aim of this module is to provide learners with an understanding of the principles and concepts of financialaccounting, technicalcompetency indouble-entrybookkeepingandpreparationoffinancialstatements for various types of reporting entities.

SYLLABUS ELEMENTS AND WEIGHTINGSAccounting fundamentals 10%

Accounting for transactions and events 25%

Trial balance, control accounts, reconciliations, and correction of errors 20%

Preparationofbasicfinancialstatements 25%

SpreadsheetMethodsforfinancialaccounting 20%

100%

MINIMUM INTENDED MODULE LEARNING OUTCOMES

Upon completion of this module, the learner will be able to:

1. Understandthepurposeandscopeoffinancialaccounting.

2. Account for a range of transactions and events.

3. Identify errors and correct them, reconcile bank accounts, and extract a trial balance from an accounting ledger.

4. Preparebasicfinancialstatementsforasoletrader,partnership,andlimitedliabilitycompany.

5. Apply basic spreadsheet skills to assist with the preparation of business information.


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CRITERIA FOR ACHIEVEMENT OF MODULE LEARNING OUTCOMES

The achievement of a module learning outcome will be determined by reference to the criteria listed below.

1. Understandthepurposeandscopeoffinancialaccounting

• Explaintheobjectivesoffinancialaccounting.

• Give examples of types of users of accounting information.

• Distinguishbetweenfinancialaccountingandmanagementaccounting.

• Explainthemainelementsoffinancialstatements.

• Identifythecontentsofacompletesetoffinancialstatements.

• Explainthequalitativecharacteristicsoffinancialstatements.

• Distinguish between sole traders, partnerships, and limited liability companies as reporting entitiesforfinancialaccountingpurposes.

• Summarise the regulatory framework that applies to each of sole traders, partnerships, and limited liability companies.

• Explain the meaning of ‘true and fair’/’presents fairly’.

• Describe the roles and responsibilities of accountants and auditors.

• Summarise the requirements of reporting entities to maintain accounting records.

• Outlinethenatureofethicalissuesinfinancialaccounting.

2. Account for a range of transactions and events

• Explain how the accounting equation is the basis of double-entry bookkeeping.

• Explain the accruals basis of accounting.

• Demonstrate how books of prime entry, ledger accounts and journals are related to each other.

• Identify the typical source documentation that underpins accounting transactions.

• Apply the principles of double-entry bookkeeping and the accruals basis of accounting to account for a range of transactions and events.

3. Identify errors and correct them, reconcile bank accounts, and extract a trial balance from an accounting ledger

• Prepare control accounts for receivables and payables.

• Prepare bank reconciliation statements.

• Giveexamplestoillustratehowaccountingerrorscanaffectthetrialbalanceand/orfinancialstatements.

• Demonstrate by means of accounting journals how accounting errors are corrected (including use of a suspense account where appropriate).

• Extract a trial balance.

• Discuss the limitations of a trial balance.


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4. Preparebasicfinancialstatementsforasoletrader,partnership,andlimitedliabilitycompany

• Make accounting adjustments to a trial balance.

• Prepare capital accounts, current accounts, and an appropriation account for a partnership.

• Explain how the capital structure of a limited liability company (with equity and debt sources offinance)differsfromthatofasoletraderornon-incorporatedpartnership.

• Prepareanincomestatement,anappropriationaccountandstatementoffinancialposition.

• Explainhowtheobjectivesoffinancialstatementsofa‘notforprofit’entitymaydifferfromthoseofaprofit-orientedentity.

• Demonstratehowthestructureandcontentoffinancialstatementsofa‘notforprofit’entitycandifferfromthoseofa‘profit-oriented’entity.

5. Apply basic spreadsheet to assist with the preparation of business information.


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MODULE: FINANCIAL ACCOUNTINGDetailed curriculum

Specific Functional Knowledge and Competencies

Understanding Application Analysis

Accounting Fundamentals (10%)

Content and scope of accounting l l

Explain the nature, scope, and objectives ofaccountingingeneralandfinancialaccounting in particular

l l

Give examples of users of accounting information

l l

Distinguishbetweenfinancialaccountingand management accounting

l l

Explainthemainelementsoffinancialstatements

l l

Identify the complete contents of a set of financialstatements

l l

Explain the following qualitative characteristicsoffinancialinformation:understandability, relevance, materiality, reliability, substance over form, prudence, completeness, comparability, timeliness, cost/benefittradeoff.

l l

Types of business entities l l

Distinguish between sole traders, partnerships, limited companies and not for profitreportingentities

l l

Summarise the extant regulatory frameworks for each type of business entity

l l

Explain the meaning of 'true and fair view' l l

Outline the roles and responsibilities of each of accountants and auditors

l l

Outline the nature of ethical issues that can ariseinfinancialaccounting

l l


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Accounting for transactions and events (25%)

Principles of double-entry bookkeeping

Explain how the accounting equation is the basis of double-entry bookkeeping and the preparationoffinancialstatements

l

Explain the accruals basis of accounting (as distinct from cash-based accounting)

l

Explain the principle of offsetting and how it appliestofinancialaccounting

l

Illustrate the relationship between books of prime entry, ledger accounts and journals

l

Identify the typical source documentation that underpins accounting transactions

l

Summarise the requirements of reporting entities to maintain adequate accounting records

l

Practise of double-entry bookkeeping

Account for sales and purchase transactions (including returns, discounts, and VAT)

l l

Account for cash and petty cash transactions

l l

Account for receivables (including irrecoverable debt write offs) and payables

l l

Account for inventories (opening and closing, recognition and measurement)

l l

Account for wages, PAYE, PRSI/NIC, USC l l

Account for capital expenditure and revenue expenditure

l l


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Trial balance, control accounts, reconciliations, and correction of errors (20%)

Trial balance

Explain the nature and purpose of a trial balance

l

Demonstrate how to balance ledger accounts and extract a trial balance on a periodic basis

l l

Discuss the limitations of a trial balance l

Control accounts

Explain the nature and purpose of control accounts

l

Prepare control accounts for receivables and payables

l l

Prepare control account reconciliations to sub-ledgers for receivables and payables

l l

Bank reconciliations

Explain the nature and purpose of a bank reconciliation

l

Correctidentifiedcashbookerrors/omissions in the context of a bank reconciliation

l l

Prepare a bank reconciliation statement. l l

Correction of errors

Summarise the types of accounting errors thatariseandtheimpactonfinancialstatements

l

Draft journal entries to correct errors l l

Explain the nature and purpose of a suspense account

l

Account for the creation and subsequent elimination of a suspense account

l l


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Preparation of basic financial statements (25%)

Sole trader

Explain the concepts of owner equity capital, profitorlossanddrawings l

Prepare an income statement and statement offinancialposition(orextractsthereof)based on underlying ledger balances (including a trial balance) for a sole trader

l l

Account for the following period end adjustments as part of process of preparing asoletrader'sfinancialstatements:sales, purchases, cash, petty cash, receivables, payables, inventories, wages and salaries, capital expenditure, revenue expenditure, depreciation, disposals of non-current assets, period end accruals and prepayments, errors/omissions, and reconciliations.

l l

Limited company

Explain the main differences between financialstatementsof(a)soletraderand(b) limited company

l

Describe the capital structure of a limited company - equity (ordinary share capital, share premium, retained earnings, equity dividend distribution) and debt (loans and debentures)

l

Account for issues of share capital (potentially at a premium) and equity dividend distributions

l l

Prepare an income statement and statement offinancialposition(orextractsthereof)based on underlying ledger balances (including a trial balance) for a limited company

l l

Account for the following period end adjustments as part of process of preparing alimitedcompany'sfinancialstatements:sales, purchases, cash, receivables, payables, inventories, capital expenditure, revenue expenditure, depreciation, disposals of non-current assets, period end accruals and prepayments, errors/omissions, reconciliations, share issues and dividend distributions

l l


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Partnerships

Explain the main differences between financialstatementsof(a)soletraderand(b) partnerships

l

Explainthesignificanceofcapitalaccounts,currentaccounts,andprofitappropriationinthe context of a partnership

l

Accountforpartnerprofitsharesbasedonspecifiedprofit-sharingratios

l l

Prepare an income statement, appropriation accountandstatementoffinancialposition(or extracts thereof) based on underlying ledger balances (including a trial balance) for a partnership

l l

Account for the following period end adjustments as part of process of preparing apartnership'sfinancialstatements:sales,purchases, cash, receivables, payables, inventories, capital expenditure, revenue expenditure, depreciation, disposals of non-current assets, period end accruals and prepayments, errors/omissions, reconciliations,profit-sharingarrangements,and appropriations

l l

Not for profit entities

Explaintheobjectivesoffinancialstatementsfor'notforprofit'entities(including consideration of the meaning of equity)

l

Prepare a receipts and payments account or an income and expenditure account and a statement of accumulated fund for a 'not forprofit'entitybasedonunderlyingledgerbalances

l l

Account for club subscription income (including prepayments and accruals)

l l


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Spreadsheet Skills (MS Excel)

Investigate a range of uses for spreadsheets generallyandfinancialaccountingspecifically

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Nameandstoreaspreadsheetfileinaccordancewithaspecificnamingconvention

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Enter data accurately (manually enter data, link cells within and across worksheets, remove duplications)

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Update existing data or parameters accuratelyandefficiently

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Use a range of appropriate formatting tools to aid understanding and to present accounting information effectively (see Excel skills list)

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Use a range of formulas to manipulate and analyse the data (see Excel skills list)

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Use a range of mathematical and logical functions (see Excel skills list)

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Use formula auditing and error checking tools

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Use data validation to restrict editing l l

Protect cells and worksheets l l

Use passwords l l

Developaspreadsheetforafinancialaccounting purpose

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xxix


MS EXCEL SKILLS

Design and format Validity and accuracy

Column width and row height Check validity of results

Cellfillcolour Check links

Copy and paste, cut, and paste Data validation

Fonttypeandcolour,size,bold,italics Error checking

Find and replace Removal of duplicates

Freezingrowsandcolumns Functions

Headers and footers NOW

Hiding and unhiding rows and columns SUM

Hiding and showing formulas TODAY

Insert rows and columns COUNT

Locking and unlocking cells COUNTA

Naming and re-naming worksheets COUNTIF

Password protection of a worksheet/range of cells IF

Page orientation LOOKUP

Page setup AVERAGE

Renamingfiles MAX

Saving as csv, PDF, xlsx MIN

Spell check ROUNDUP

Wrapping text ROUNDDOWN

Data Formulas

Cell referencing Add, subtract, multiply, divide

Linking data across several worksheets

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CHAPTER 1: INTRODUCTION TO ACCOUNTING

CHAPTER 1

Introduction to Accounting

LEARNING OUTCOMES

On completion of this chapter, students should be able to:

1. Understand the nature, scope, and objectives of accounting

2. Distinguish between Financial Accounting and Management Accounting

3. Set out the users of the accounting information and describe their information needs

4. Outlinethecontentsofasetoffinancialstatements

5. Explainthemainelementsoffinancialstatements

6. Outline the qualitative characteristics of useful accounting information

REVISION RESOURCES

Practise questions are available on MyRevision. They are an essential teaching and learning resource for Financial Accounting.

Chapter 1 : Introduction to Accounting

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1.1 ACCOUNTINGAccountingistheartofcommunicatingfinancialinformationaboutanorganisationtointerestedparties.Accountinginformationiscommonlypresentedtointerestedpartiesintheformoffinancialstatements.Thischapterexplorestheconceptofaccounting,identifiesthetypesofusersofaccountinginformation(the ‘interested parties’), describes the common contents of financial statements and explains thequalities that accounting information should have for it to be useful to interested parties.

Accountingcanbedefinedasthe process of identifying, recording, and communicating economic information to permit informed judgments and decisions by users of that information.

Accounting is all about generating and communicating useful information to interested parties. Accounting information relates to the financial or economic activities of an organisation and is systematicallyrecordedinaccountingledgers.Theunderlyingsystembywhichfinancialandeconomicactivitiesarerecorded is known as double-entry bookkeeping.

There are several ways in which accounting information can be communicated to interested parties (examples include annual reports and monthly management accounts). The nature of the communication varies depending on who is the interested party so the means of communication requires us to understand who the users of the accounting information are and their information needs.

1.2 TYPES OF ACCOUNTINGThe two main types of accounting are: financialaccountingandmanagement accounting.

Financial Accounting is oriented to users of accounting information who are external to the organisation. External users include investors, suppliers, customers, employee representatives (such as trade unions), lenders, analysts, competitors, local and central government, and the public at large (see also Section 1.3).

Theobjectiveoffinancialaccounting(toprovideusefulinformationtointerestedpartieswhoareexternaltotheorganisation)isusuallyachievedbymeansofthepreparationoffinancialstatements.Financialstatements are prepared by reference to generally accepted accounting conventions and regulatory standards.

Management accounting is oriented to users of accounting information who are internal to the organisation. Internal users include management (and includes executive level employees).

Management need more detailed and up-to-date information than is typically available in financialstatements. The objective of management accounting (to provide useful information to interested parties who are internal to the organisation) is usually achieved through bespoke reports. Management accounting provides information to enable, for example, costing of products, costing of production methods,assessmentsofprofitabilitybyproductandbydepartment.

In broader terms, management accounting contributes to formulation of strategy, planning and controlling activities, decision-making and optimising the use of potentially scarce resources.


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Table 1: A summary comparison of Financial Accounting and Management Accounting.

Financial Accounting Management Accounting

Purpose Productionoffinancialstatements for external users for decision-making purposes.

Production of detailed accounts, used by management to control the business and make plans.

Frequency Usually annually or semi-annually.

Historically, management accounts were prepared monthly. More recently, they are prepared as frequently as is required by management. Real-time reporting is increasingly the norm.

Stimulus Required by law and/or for tax purposes.

To aid management decision making - not required by law.

Focus of information Reflectspastperformance and current position.

Includes budgets and forecasts of future activities, as well as assessing past performance.

Framework Regulatory framework forfinancialaccountingdetermines the contents offinancialstatements.

There is no regulatory framework for management accounting so the framework may differ from one organisation to another. Information should be useful to managers.

You will study Management Accounting in the second year of this programme. The remainder of this manual focuses on Financial Accounting.

1.3 USERS OF FINANCIAL ACCOUNTING INFORMATIONAlthough there are differences in the types of information presented by financial accounting andmanagement accounting, the underlying objective is the same – to satisfy the information needs of the interested parties, otherwise referred to as usersofaccountinginformation.Theusersoffinancialaccountinginformationcanbebroadlyclassifiedasfollows:

1.3.1 Investors

Investors are concerned about risk and return in relation to their investments and potential investments. They therefore require information to decide whether they should continue to invest in a business or make alternative investment choices.

Key accounting information for an investor includes:

• Information about growth, sales, volumes.

• Profitability(profitmargins,overalllevelofprofit).

• Investment in assets, levels of debt.

• Business value.


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1.3.2 Lenders

Banks that lend money to a business require information that helps them determine whether loans and financecostswillbepaidwhendue.

Key accounting information for lenders includes:

• Level of existing debt.

• Cashflowstoascertainavailabilityofcashwhenloanrepaymentsaredue.

• Assets against which the lending may be secured.

1.3.3 Suppliers

Suppliers want to know whether they will be paid for goods and services that they provide to an organisation. They are therefore interested to understand and assess the short-term liquidity of an organisation. For example, does the organisation appear to be able to pay its short-term debts when they fall due?

Key accounting information for suppliers includes:

• Cashflow.

• Management of working capital.

• Terms of trade and payments policies.

1.3.4 Customers

Customers want reassurance that an organisation will be able to supply goods and services to them when required. Customers will therefore be interested in the ability of an organisation to survive, grow and prosper. Customers also have an interest in an organisation’s range of products and services and may even be dependent on an organisation for certain products and services.

Key accounting information for customers includes:

• Sales growth.

• New product development.

• Terms of trade.

• Investment in the business (for example, production capacity).

1.3.5 Competitors

Organisations that operate in the same industry are interested to know how the competition is performing. They want to benchmark their performance against similar organisations or the industry in general. Competitorswouldbeinterestedinlevelofsales(marketshare),profitmargins,externaldebt,andassetgrowth. This information may indicate a need to make new investments or suggest that an organisation isunder-performingintermsofcostcontrolorprofitability.


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1.3.6 Employees

Employees (and organisations that represent them, such as trade unions) require information about the stability and continuing profitability of the business. They are interested in information aboutemploymentprospects,themaintenanceofpensionfundsandretirementbenefits.Theyarealsolikelytobeinterestedinthepayandbenefitsobtainedbyseniormanagement.

Key accounting information for employees includes:

• Salesandprofitgrowth.

• Levels of investment in the business.

• Overall employment data (numbers employed, wages and salary costs).

• Status and valuation of the company pension schemes/levels of company contributions.

1.3.7 Government

Central and local government agencies and departments are interested in accounting information. Forexample,thetaxauthoritiesareinterestedinprofitabilityfortaxpurposes(including,forexample,income tax, corporation tax and value added tax). Local government agencies are interested in similar information for the purposes of levying local taxes and rates. Various regulatory agencies are also interested in accounting information that supports, for example, decisions on grants.

1.3.8 Analysts

Analystsrequiredetailedfinancialandnon-financialinformationtoanalysethecompetitiveperformanceofabusinessanditssector.Inadditiontoinformationthatisavailabletoanalystsinfinancialstatements,information is commonly provided to analysts bymeans of briefings by seniormanagement of theorganisation and media interviews.

1.3.9 Public at large

Interestgroupsthathaveaspecificinterestintheactivitiesandperformanceofbusinesses,willalsobe interested in accounting information. Examples include resident committees where a business is in a residential area and environmental groups who have an interest in the environmental impacts of business organisations.


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1.4 FINANCIAL STATEMENTSTheobjectiveoffinancialaccountingistomeettheinformationneedsofexternalusersofaccountinginformationandthisobjectiveisachievedbymeansofpreparingfinancialstatements.Acompletesetoffinancialstatementsincludesthefollowing:

1.4.1 Statement of financial position

Astatementoffinancialposition(otherwisecommonlyknownasa‘balancesheet’)listsanorganisation’sassets, liabilities, and equity (otherwise commonly known as ‘owner capital’) at each reporting date. It canbehelpfultothinkofastatementoffinancialpositionasafinancialphotographofanorganisation–thepicturepresentsthefinancialpositionoftheorganisationintermsofassets,liabilities,andequityatasinglepointintime(whichisthereportingdate).Averybasicexampleofastatementoffinancialposition is as follows:

[Name of organisation]Statement of Financial Position as at 31 December 20X9

€Total assets 100

Liabilities 75

Owner equity 25

100

In thisbasicexample, the statementof financial positionasat 31December20X9 tells us that theorganisation controls assets amounting to €100, liabilities (obligations to third parties who have claims over the assets) amount to €75, and the residual €25 (amount remaining after the liabilities are settled) is attributable to the owners of the business.

1.4.2 Income statement

An income statement presents the income earned and expenses incurred by an organisation during a reportingperiod.Forprofit-orientedorganisations,thepurposeofanincomestatementistocalculatewhethertheorganisationmadeaprofitoralossforthereportingperiod(whichismostcommonlyayearin duration). An income statement is a performance statement because it measures how an organisation has performed during the year. A basic example of an income statement is as follows:

[Name of organisation]Income Statement for the year ended 31 December 20X9

€Income 100

Expenses (85)

Profit for the year 15


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In this basic example, the income statement tells us that the organisation earned income of €100 during theyear,incurredexpensesof€85duringtheyearand,therefore,earnedaprofitof€15fortheyear.

1.4.3 Statement of cash flows

A statement of cash flows presents the cash inflow and cash outflows of an organisation during areporting period. Like the income statement, it is a performance statement but differs from the income statement in that, whereas the income statement measures income and expenses, the statement of cashflowsmeasurescashinflowsandcashoutflows.

Youwillstudythepreparationofthestatementofcashflowsinthesecondyearofthisprogramme.Itisnotanexaminabletopicinthefirstyearofthisprogramme.

1.4.4 Statement of changes in equity

A statement of changes in equity explains how the equity of an organisation has changed during the year. For example, if a company issues shares or pays a dividend during the year (both of which are changes in the owner equity of an organisation), this information is presented on a statement of changes in equity.

You will study the preparation of the statement of changes in equity in the second year of this programme. Itisnotanexaminabletopicinthefirstyearofthisprogramme.

1.4.5 Notes to the financial statements

Notestothefinancialstatementsprovideadditionaldetailsinrelationtoassets,liabilities,equity,income,expenses,andcashflowsthatarepresentedinthestatementoffinancialposition,incomestatement,statementsofcashflowsorstatementofchangesinequity.Notestothefinancialstatementscanalsoinclude other explanatory information that is considered useful to interested parties.

Youwill study notes to the financial statements in the second year of this programme. It is not anexaminabletopicinthefirstyearofthisprogramme.

At this point, you are encouraged to download the annual report of any well-known company (such as AmazonorMicrosoft)andtobrowsethefinancialstatementstosatisfyyourselfthattheyincludeincomestatements,statementsoffinancialposition,statementsofchangesinequity,statementsofcashflowsandnotestothefinancialstatements.

Theremainderofthiscoursemanualfocusesonthefinancialaccountingknowledgeandunderstandingrequired to account for transactions and events from their initial recording in an organisation’s accounting ledgers to preparation and presentation of the organisation’s income statement and statement of financialposition.


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1.5 ELEMENTS OF FINANCIAL STATEMENTSThetechnicalnatureoffinancialaccountingrequiresustobefamiliarwithitsvocabulary.Itisimportantto familiariseyourselfwith thebasicvocabularyoffinancialaccounting inadvanceof thedetail thatfollows in subsequent chapters.

1.5.1 Assets

Assets are economic resources controlled by the organisation that can be put to productive use for thefuturebenefitoftheorganisation.Examplesincludebuildings,equipment,machinery,furnitureandfittings,motorvehicles,inventoriesofgoodsthatareavailableforsale,amountsowedtotheorganisationby customers, money in the bank and cash in hand. Assets are listed on the organisation’s statement offinancialposition.

1.5.2 Liabilities

Liabilities are obligations to third parties (other than the owners of the business) that must be settled at some point in the future. Examples include outstanding bank loans, bank overdrafts and amounts owed tosuppliers.Liabilitiesarelistedontheorganisation’sstatementoffinancialposition.

1.5.3 Owner equity

Owner equity, otherwise known as owner capital, is the residual amount of assets attributable to the owner(s) of the business once the liabilities are settled.

1.5.4 Income

Income most commonly arises from the provision of goods and services to customers. This form of income is more generally known as sales or revenue. Other forms of income include rental income (from lettingapremises)andinterestincome(fromfinancialinvestments).

1.5.5 Expenses

An expense is a cost of carrying on a business. Examples include the cost of buying goods for re-sale and overhead costs such as electricity, wages, and insurance. As you will see, accounting for expenses dependson(1)thenatureoftheexpense,and(2)whetherthebenefitoftheexpensewillberealisedinits entirety in the current reporting period or will also be realised in future reporting periods.

1.6 QUALITIES OF USEFUL INFORMATIONThe objective of financial statements is to provide information about the reporting entity’s financialperformance(incomestatement)andfinancialposition(statementoffinancialposition)ofanorganisationthat is useful to a wide range of users in making economic decisions.

The question arises as to what constitutes ‘useful’ information? In other words, what qualities should the informationincludedinfinancialstatementshaveforustobeabletoconcludereasonablythatitislikelyto be useful to a wide range of users?


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According to the Financial Reporting Standard (FRS) 102 issued by the Financial Reporting Council in theUK,wecanreasonablyconcludethatfinancialstatementsarelikelytobeusefuliftheyhavethefollowing qualitative characteristics.

1.6.1 Understandability

‘The information provided in financial statements should be presented in a way that makes it comprehensible by users who have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence.’ (FRS 102, Section 2.4).

1.6.2 Relevance

‘The information provided in financial statements must be relevant to the decision-making needs of users. Information has the quality of relevance when it is capable of influencing the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations.’ (FRS 102, Section 2.5).

1.6.3 Materiality

‘Information is material – and therefore has relevance – if its omission or misstatement, individually or collectively, could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor.’ (FRS 102, Section 2.6).

1.6.4 Reliability

‘The information provided in financial statements must be reliable. Information is reliable when it is free from material error and bias and represents faithfully that which it either purports to represent or could reasonably be expected to represent. Financial statements are not free from bias (i.e., not neutral) if, by the selection or presentation of information, they are intended to influence the making of a decision or judgement in order to achieve a predetermined result or outcome.’ (FRS 102, Section 2.7).

1.6.5 Substance over form

‘Transactions and other events and conditions should be accounted for and presented in accordance with their substance and not merely their legal form. This enhances the reliability of financial statements.’ (FRS 102, Section 2.8).

1.6.6 Prudence

‘Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. However, the exercise of prudence does not allow the deliberate understatement of assets or income, or the deliberate overstatement of liabilities or expenses. In short, prudence does not permit bias.’ (FRS 102, Section 2.9).


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1.6.7 Completeness

‘To be reliable, the information in financial statements must be complete within the bounds of materiality and cost. An omission can cause information to be false or misleading and thus unreliable and deficient in terms of its relevance.’ (FRS 102, Section 2.10).

1.6.8 Comparability

‘Users must be able to compare the financial statements of an entity through time to identify trends in its financial position and performance. Users must also be able to compare the financial statements of different entities to evaluate their relative financial position, performance, and cash flows. Hence, the measurement and display of the financial effects of like transactions and other events and conditions must be carried out in a consistent way throughout an entity and over time for that entity, and in a consistent way across entities.’ (FRS 102, Section 2.11).

1.6.9 Timeliness

‘To be relevant, financial information must be able to influence the economic decisions of users. Timeliness involves providing the information within the decision time frame. If there is undue delay in the reporting of information it may lose its relevance. Management may need to balance the relative merits of timely reporting and the provision of reliable information. In achieving a balance between relevance and reliability, the overriding consideration is how best to satisfy the needs of users in making economic decisions.’ (FRS 102, Section 2.12).

1.6.10 Balance between cost and benefit

‘The benefits derived from information should exceed the cost of providing it. The evaluation of benefits and costs is substantially a judgemental process. Furthermore, the costs are not necessarily borne by those users who enjoy the benefits, and often the benefits of the information are enjoyed by a broad range of external users.’ (FRS 102, Section 2.13).

1.7 SUMMARY AND CONCLUSIONSThe purpose of accounting is to provide useful information to a wide range of users. If accounting information is not useful to one or more types of users, then the accounting information serves no purpose.

Thetwobranchesofaccountingarefinancialaccountingandmanagementaccounting.Thepurposeoffinancialaccountingistoservetheinformationneedsofuserswhoareexternaltoanorganisation(namely investors, suppliers, customers, employee representatives (such as trade unions), lenders, analysts, competitors, local and central government) and the purpose of management accounting is to serve the information needs of management, i.e., users who are internal to an organisation.

The informationneedsofuserswhoareexternal toanorganisationarecommonlymetbyfinancialstatements.Asetoffinancialstatementsincludesastatementoffinancialposition,anincomestatement,astatementofcashflows,astatementofchangesinequityandnotestothefinancialstatements.Youarerequiredtofocusyourattentiononthestatementoffinancialpositionandtheincomestatementforthefirstyearoftheprogramme.


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Studentswhoarenew to financial accountingmust familiarise themselveswith financial accountingvocabulary. From the outset, it is important to be able to explain the meaning of ‘assets’, ‘liabilities’, ‘equity’,‘income’and‘expenses’astheyapplytofinancialaccounting.

Itisalsoimportanttobeabletoexplainthemeaningof‘useful’informationinthecontextoffinancialaccounting.Thisnecessitatesanabilitytoexplainthequalitativecharacteristicsofinformationinfinancialstatements: ‘understandability’, ‘relevance’, ‘materiality’, ‘reliability’, ‘substance over form’, ‘prudence’, ‘completeness’,‘comparability’,‘timeliness’,and‘balancebetweencostandbenefit’.

In chapter 2, we introduce the basic mechanics of double-entry bookkeeping (commonly abbreviated to ‘DEBK’).

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CHAPTER 2: DOUBLE-ENTRY BOOKKEEPING

CHAPTER 2

Double-Entry Bookkeeping

LEARNING OUTCOMES


1. Explain the accounting equation as the basis of double-entry bookkeeping

2. Explain the rules of double-entry bookkeeping as they apply to assets, liabilities, equity, income, and expenses

3. Account for basic cash transactions, credit transactions, prompt payment settlement discounts, capital expenditure, and revenue expenditure

4. Record transactions in ledger accounts and balance off ledger accounts on a periodic basis

5. Extract a Trial Balance

REVISION RESOURCES


Chapter 2 : Double-Entry Bookkeeping

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2.1 THE ACCOUNTING EQUATIONBookkeeping is the skill of keeping a systematic record of the economic transactions that are entered intobyanorganisation.Formanyyears,financialaccountinghasbeenunderpinnedbydouble-entrybookkeeping, which is a particular method of keeping record of transactions that is based on the accounting equation.

The accounting equation states that:

Assets = Liabilities + Equity

Some points to note about the accounting equation:

• Thisdeceptivelysimpleequationisthefoundationofahugeamountoffinancialaccounting.

• The concepts of assets, liabilities and equity are explained in chapter 1. Equity is otherwise known as ‘capital’.

• The accounting equation must always be true. This means that the accounting equation must return to equilibrium (assets = liabilities + equity) after a transaction is recorded in the accounting records. There are no exceptions to this rule.

• Double-entry bookkeeping is the method that ensures the accounting equation returns to equilibrium after each transaction.

• It is difficult to be competent in financial accounting if you are not competent in double-entrybookkeeping.

Example 1

Day 1:

On Day 1 of January 20X5, Joe establishes a business called JoeCo, opens a business bank account in the name of JoeCo, and transfers €10,000 of his personal savings to the business bank account.

As a result of this first business transaction entered into by JoeCo,what does JoeCo’s accountingequation look like at the end of Day 1?

JoeCo’s accounting equation at the end of Day 1 is as follows:

Assets (€10,000) = Liabilities (€0) + Equity (€10,000).

JoeCo’s asset is the €10,000 lodged to the business bank account and the equity is the amount that is attributable by JoeCo to Joe (in other words, the equity capital that Joe invested in the business).

Day 2:

On Day 2, JoeCo obtains a loan of €7,500 from the bank and this amount is lodged to the business bank account. What does JoeCo’s accounting equation look like at the end of Day 2?


Assets (€17,500) = Liabilities (€7,500) + Equity (€10,000)


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Day 2’s transaction is added to Day 1’s transaction. In total, assets now amount to €17,500 (being the €10,000 lodged by Joe and the receipt of the €7,500 loan). A liability (€7,500) exists at the end of Day 2 because the loan from the bank will have to be repaid at some point in the future. The equity (€10,000) is the equity capital that Joe invested in JoeCo.

Day 3:

JoeCo repays €1,000 of the loan. An amount of €1,000 is transferred from the business bank account to reduce to the amount of the loan. What does JoeCo’s accounting equation look like at the end of Day 3?


Assets (€16,500) = Liabilities (€6,500) + Equity (€10,000)

Day 3’s transactions are added to the sum of Day 1 and Day 2’s transactions. In total, assets now amount to €16,500 because €1,000 was used to repay part of the bank loan. The liability at the end of Day 3 is €6,500 because part of the loan has been repaid and the remaining liability (amount that must be settled at some point in the future) is therefore less than it was on Day 2. There is no change to equity on Day 3.

The key points to note from three days of JoeCo’s transactions:

• The accounting equation is in equilibrium at the end of each day’s transactions.

• Each of the assets, liabilities, and equity can increase or decrease depending on the transaction.

• Increases and decreases in assets result in corresponding increases and/or decreases in other assets, liabilities and/or equity to bring the accounting equation back to equilibrium. We therefore say that each transaction has a ‘two-fold’ effect on the accounting equation – every transaction affects the accounting equation in two ways through some combinations of increases/decreases in assets, liabilities, and equity. In general, this two-fold effect of transactions on the accounting equation is referred to as the concept of ‘duality’.

• From an accounting perspective, ‘Joe’ is not the same as ‘JoeCo’. In other words, the business entity ofJoeCoisseparatetoJoetheowner.Joe’sfinancialinterestinJoeCoisevidentfromtheinclusionof €10,000 equity in the accounting equation – this is recognition of the fact that €10,000 of JoeCo’s assets are attributable to Joe (the rest of the assets being attributable to the bank that provided the loan). But JoeCo is a separate entity to Joe - this separation of the business from the owners is referred to in accounting as the ‘business entity’ concept.


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2.2 DOUBLE-ENTRY BOOKKEEPINGDouble-entry bookkeeping is based on the concept of duality (hence the term double-entry bookkeeping) and requires us to be familiar with the terms ‘debit’ and ‘credit’.

The JoeCo example illustrates that transactions result in increases and decreases in assets, liabilities, and equity. We use the terms ‘debit’ and ‘credit’ in accounting to describe increases and decreases in assets, liabilities, and equity.

2.2.1 Rules of Double-Entry Bookkeeping

The rules of double-entry bookkeeping are as follows:

Increase Decrease

Asset Debit Credit

Liability Credit Debit

Equity Credit Debit

Therefore, to debit an asset is to increase the amount of the asset and to credit an asset is to decrease the amount of that asset.

To credit a liability is to increase the amount of the liability and to debit a liability is to decrease the amount of that liability.

To credit equity is to increase the amount of equity and to debit equity is to decrease the amount of equity.

Example 2

Withreferencetotherulesofdouble-entrybookkeeping,thefirstthreedaysofJoeCo’stransactionsarerecorded as follows:

Day 1:

Debit (increase) the assets and credit (increase) the equity by €10,000.

Day 2:

Debit (increase) the assets and credit (increase) the liabilities by €7,500.

Day 3.

Debit (decrease) the liabilities and credit (decrease) the assets by €1,000.


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2.2.2 Applying Double-Entry Bookkeeping rules to specific Asset, Liability and Equity Accounts

To provide useful information to interested parties, double-entry bookkeeping needs to be more detailed than we have presented so far. In practise, JoeCo’s three days of transactions would be recorded in the accounting records as follows:

Account Effect € €Day 1

Dr Bank Increase in asset 10,000 Cr Owner equity Increase in equity 10,000

Day 2 Dr Bank Increase in asset 7,500 Cr Loan Increase in liability 7,500

Day 3 Dr Loan Decrease in liability 1,000 Cr Bank Decrease in asset 1,000

Note the following:

• Each of these bookkeeping entries on each of Days 1, 2 and 3 is referred to as an ‘accounting journal’.

• ‘Dr’ is shorthand for debit and ‘Cr’ is shorthand for credit.

• Insteadofreferringtoassets,liabilities,andequityingeneral,werefertospecificassets,liabilities,and equity (namely the bank account (asset), loan account (liability) and owner equity (equity account)). Consequently, it is possible to have as many asset, liability, and equity accounts as is necessary to maintain a comprehensive, useful, and systematic record of the economic transactions.

• The ‘Effect’ column is included in the table for educational purposes to remind you of the effect of a debit or credit on assets, liabilities, and equity.

2.2.3 Double-Entry Bookkeeping Rules for Income and Expenses

In addition to assets, liabilities and equity, chapter 1 introduces income and expenses. How do the rules of double-entry bookkeeping apply to income and expenses?

The rules of double-entry bookkeeping for income and expenses are as follows:

Increase Decrease

Income Credit Debit

Expenses Debit Credit

Therefore, to credit income is to increase the amount of that income and to debit income is to decrease the amount of that income.

To credit a liability is to increase the amount of the liability and to debit a liability is to decrease the amount of that liability.


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Example 3

JoeCo is in the business of buying recyclable plastic bottles from manufacturers and selling them to customers that bottle and sell spring water.

Day 4:

JoeCo buys 2,000 plastic bottles from a manufacturer for €2,400 and pays for the purchase immediately by means of a bank transfer.

Day 5:

JoeCo sells 1,000 plastic bottles to a spring water company for €6,100 and receives payment immediately by means of a bank transfer.

The accounting journals to record JoeCo’s Day 4 and Day 5 transactions are as follows:

Account Effect € €

Day 4

Dr Purchases Increase in expense 2,400

Cr Bank Decrease in asset 2,400

Day 5

Dr Bank Increase in asset 6,100

Cr Sales Increase in income 6,100

Note the following:

• The term ‘purchases’ is reserved solely for the purpose of referring to the purchase of items that are the stock in trade of the business (recyclable plastic bottles in the case of JoeCo). JoeCo may buy manyotherthingsaspartofcarryingonbusinesssuchasstationeryfortheoffice,insurancecover,electricity supply, employee labour and many other expenses but none of those other expenses are described as ‘purchases’ if they are not the stock in trade of the business. Purchases therefore has aspecificmeaninginfinancialaccounting.

• Similarly, the term ‘sales’ is reserved solely for the purpose of referring to the sale of items that are the stock in trade of the business. There may be other kinds of income that JoeCo may earn such as deposit interest or rental income but only the sale of recyclable plastic bottles would be described as ‘sales’.‘Sales’thereforehasaspecificmeaninginfinancialaccounting.

• The stock in trade of an organisation is commonly referred to as ‘goods’. When you see a reference to ‘goods’, it is referring to the purchase or sale of the stock in trade of the organisation.

• The purchase of goods on Day 4 resulted in an increase in an expense (purchases) and a decrease in an asset (bank). The sale of goods on Day 5 resulted in an increase in an asset (bank) and an increase in income (sales).

• At this point, you may be wondering how the accounting equation returns to equilibrium after either Day 4 and Day 5 transactions given that income and expenses do not appear to be part of the accounting equation. The accounting equation appears to be affected only by the credit (decrease in asset) on Day 4 and the debit (increase in asset) on Day 5.


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• The answer is that income and expenses ultimately affect equity – this is something that will become clearer to you in later chapters of this course manual. Income (such as sales on Day 5) is, ultimately, an increase in equity and expenses (such as purchases on Day 4) are, ultimately, decreases in equity. If we re-phrase the Day 4 and Day 5 accounting journals as follows, it becomes evident that the accounting equation returns to equilibrium at the end of each day.


Day 4 Dr Purchases Decrease in equity 2,400 Cr Bank Decrease in asset 2,400

Day 5 Dr Bank Increase in asset 6,100 Cr Sales Increase in equity 6,100

Becomingproficientindouble-entrybookkeepingis,forthemostpart,amatterofpractise.Documentingaccounting journals accurately and relating the logic of debits and credits back to the accounting equation will greatly assist your understanding of much of what follows in this manual.

2.3 ACCOUNTING FOR CASH TRANSACTIONSCash transactions are those that include an immediate receipt or payment. In any organisation, cash is an asset, which means that the cash account is debited when cash increases and credited when cash decreases.

Example 4

Day 6:

JoeCo sells goods for €830 cash.

Day 7:

JoeCo pays €80 cash for rent expense.

Day 8:

JoeCo purchases goods for cash €400.

Day 9:

JoeCo pays €150 cash for business insurance.

Day 10:

A customer returns goods because they are faulty. JoeCo returns €115 cash to the customer.


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Day 11:

JoeCo returns goods to a supplier because they are faulty. The supplier returns €100 cash to JoeCo.

The accounting journals to record JoeCo’s transactions from Day 6 to Day 11 are as follows:


Day 6 Dr Cash Increase in asset 830 Cr Sales Increase in income 830

Day 7 Dr Rent Increase in expense 80 Cr Cash Decrease in asset 80

Day 8 Dr Purchases Increase in expense 400 Cr Cash Decrease in asset 400

Day 9 Dr Insurance Increase in expense 150 Cr Cash Decrease in asset 150

Day 10 Dr Sales returns Decrease in income 115 Cr Cash Decrease in asset 115

Day 11 Dr Cash Increase in asset 100 Cr Purchases returns Decrease in expense 100

Note the following:

• Increases in cash are debits and decreases in cash are credits.

• Purchases and sales are debited and credited in respect of goods bought and sold, respectively.

• Returns from customers are, by convention, debited to ‘sales returns’ rather than sales. Sales returns are otherwise known as ‘Returns Inwards’.

• ‘Purchases returns’ (rather than purchases) are credited when there are returns to suppliers. Purchases returns are otherwise known as ‘Returns Outwards’.

• Expenses other than for stock in trade (rent and insurance in this example) are not debited to purchases.Theyareclassifiedastheirowntypesofexpense(i.e.,‘insurance’and‘rent’inthecaseof JoeCo).


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2.4 ACCOUNTING FOR CREDIT TRANSACTIONSMany business transactions are undertaken on credit. For example, a sales transaction on credit is one in which the seller provides the goods or services but payment is not received from the customer until a later date. A purchases transaction on credit is one in which the supplier provides the goods or services but payment is not made to the supplier until a later date.

The question arises as to whether credit transactions should be recorded in accounting records before the payment is made. The answer is that credit transactions are recorded in accounting records when they occur even if payment is made only at a later date. The accounting concept that underpins the recording of credit transactions is known as the ‘accruals’ concept.

The accruals concept states that income should be recorded in the accounting records when it is earned and expenses should be recorded when they are incurred even though payment occurs at a different time. Application of the accruals concept is generally referred to as ‘accruals accounting’.

Example 5

Day 12

JoeCo sells goods on credit to customers for €4,500.

Day 13

JoeCo buys goods on credit from suppliers for €2,850.

Day 14

JoeCo receives payments from customers amounting to €1,900, which are lodged directly to the bank account.

Day 15

JoeCo makes cheque payments to suppliers amounting to €1,100.


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Day 12 Dr Trade Receivables Increase in asset 4,500 Cr Sales Increase in income 4,500

Day 13 Dr Purchases Increase in expenses 2,850 Cr Trade Payables Increase in liability 2,850

Day 14 Dr Bank Increase in asset 1,900 Cr Trade Receivables Decrease in asset 1,900

Day 15 Dr Trade Payables Decrease in liability 1,100 Cr Bank Decrease in asset 1,100

Note the following:

• When sales are made on credit on Day 12, no payments are received immediately from the customers. Instead, the customers owe JoeCo. In this circumstance, the customers are described on Day 12 as ‘Trade Receivables’ (otherwise commonly known as ‘Trade Debtors’). A trade receivable is an asset becausethereisafuturebenefitforJoeCo(beingthefuturereceiptoftheamountowed).Thereisa debit to Trade Receivables on Day 12 because it is an asset that has increased as a result of the sales on credit.

• When purchases are made on credit on Day 13, no payment is made immediately to the suppliers. Instead JoeCo owes the suppliers. In this circumstance, the suppliers are described on Day 13 as ‘Trade Payables’ (otherwise commonly known as ‘Trade Creditors’). A trade payable is a liability because JoeCo has an obligation to pay the suppliers at some point in the future. There is a credit to Trade Payables on Day 13 because it is a liability that has increased as a result of the purchases on credit.

• On Day 14, JoeCo received payment from some of the customers. This is the point at which there is a debit to the bank (because this is the day on which the bank balance increases). There is a corresponding credit to Trade Receivables because the Trade Receivables decrease (some customers have paid so JoeCo is owed less than was the case on Day 12).

• On Day 15, JoeCo paid some suppliers by cheque. This is the point at which there is a credit to the bank (because this is the day on which the bank balance decreases). There is a corresponding debit to the Trade Payables because the Trade Payables decrease (JoeCo has paid some suppliers so less is owed to suppliers than was the case on Day 13).


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2.5 ACCOUNTING FOR PROMPT PAYMENT SETTLEMENT DISCOUNTSSettlement discounts relate to transactions on credit. It is a normal part of business to offer a discount to trade receivables if the customer settles the amount owed within a certain period (for example within 30 days of the date of the sales invoice).

Prompt payment settlement discounts that are given to trade receivables are referred to as ‘discount allowed’.

Prompt payment settlement discounts that are received from trade payables are referred to as ‘discount received’.

Example 6

Day 16:

JoeCo receives payments from trade receivables amounting to €900, which are lodged directly to the bank account. Discounts allowed for prompt payment amount to €100.

Day 17:

JoeCo makes a bank transfer amounting to €450 to settle obligations to trade payables. Discounts received for early settlement amount to €50.

The accounting journals to record JoeCo’s transactions on Day 16 and Day 17 are as follows:


Day 16 Dr Bank Increase in asset 900 Dr Discount Allowed Increase in expense 100 Cr Trade Receivables Decrease in asset 1,000

Day 17 Dr Trade Payables Decrease in liability 500 Cr Discount Received Increase in income 50 Cr Bank Decrease in asset 450

Note the following:

• Discount received is income and discount allowed is an expense. They therefore follow the rules of double-entry bookkeeping that apply to income and expenses, respectively.

• On Day 16, the amount of the credit to Trade Receivables is inclusive of the discount allowed because this is the amount by which Trade Receivables has decreased as a result of the combination of the receipts and the discounts.

• On Day 17, the amount of the debit to Trade Payables is inclusive of the discount received because this is the amount by which Trade Payables has decreased as a result of the combination of the payments and the discounts.


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2.6 ACCOUNTING FOR CAPITAL EXPENDITUREWehaveseen,sofar,that‘expenses’inafinancialaccountingcontextcanrelateto(1)thepurchasesofstock in trade or (2) overhead expenses such as insurance and rent. In the case of purchases of stock in trade (‘goods’), the accounting debit is to ‘purchases’ and, in the case of various overhead expenses, the accounting debit is to the particular expense (for example, rent or insurance).

However, when a business spends money, it is also necessary from an accounting perspective to consider whetherthebenefitofthatexpenditurewillberealisedinitsentiretyinthecurrentreportingperiodorwhetherbenefitswillalsoberealisedinfuturereportingperiod(s).Ifthebenefitofexpenditureisrealisedby the organisation in the current reporting period only, then that expenditure is referred to as ‘revenue expenditure’. Revenue expenditure is commonly thought of as expenditure that relates to running the businessonadaytodaybasis.Butifthebenefitofexpenditureisrealisedbytheorganisationinbothcurrent and future reporting periods, then that expenditure is referred to as ‘capital expenditure’.

Typical examples of JoeCo revenue expenditure include light and heat, insurance, rent, and employee wages.Theyarecategorisedasrevenueexpenditurebecausethebenefits(specificallytheconsumptionof light and heat, occupation of the rented premises, and the labour of employees) for JoeCo are realised in the current reporting period only (subject to adjustments we will make in a later chapter in relation to accruals and prepayments).

Typical examples of JoeCo capital expenditure include buying a new motor vehicle, buying officeequipment,orconstructinganewbuilding.Ineachofthesecases,JoeCobenefitsbothinthecurrentreportingperiodandfuturereportingperiodsfromtheongoingavailabilityofthemotorvehicle,theofficeequipment, and the new building.

It is important to categorise expenditure as either capital expenditure or revenue expenditure because accounting for capital expenditure is different from accounting for revenue expenditure (as will become increasingly clear as we work through this course manual). For the purposes of this chapter, we need to know that (1) capital expenditure results in the recording of an asset (which means that the relevant rules of double-entry bookkeeping are those that apply to an asset), and (2) revenue expenditure results in the recording of an overhead expense (which means that the relevant rules of double-entry bookkeeping are those that apply to expenses).

Example 7

Day 18:

JoeCo pays rates of €650 by bank transfer.

Day 19:

JoeCo buys a motor vehicle on credit for €3,750.

Day 20:

JoeCo pays light and heat €57 by cash.

Day 21:

JoeCobuyscomputerequipmentfortheofficefor€1,390,whichispaidbycheque.


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Day 18

Dr RatesIncrease in overhead

expenses650

Cr Bank Decrease in asset 650

Day 19

Dr Motor vehicles Increase in asset 3,750

Cr Other payables Increase in liability 3,750

Day 20

Dr Light and heatIncrease in overhead

expenses57

Cr Cash Decrease in asset 57

Day 21

Dr Computer equipment Increase in asset 1,390

Cr Bank Decrease in asset 1,390

Note the following:

• Whereastheratesandthelightandheatareidentifiedasoverheadexpenses,themotorvehiclesandthecomputerequipmentareidentifiedasassets.

• Of the four transactions, one is a credit transaction and the other three result in immediate payment (whether in cash or through the business bank account).

• The motor vehicle is bought on credit. The accounting credit is to ‘Other liabilities’ rather than ‘Trade Payables’ because ‘Trade Payables’ is reserved for liabilities that arise from buying stock in trade (‘goods’) on credit (hence the term ‘trade payables’).


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2.7 LEDGER ACCOUNTSAfter 21 days of JoeCo transactions, the owner (Joe) would probably be interested to know what the overall status of the business is from the perspectives of income, expenses, assets, liabilities, and equity. Although an accounting journal is drafted for each day’s transaction, something more is required for the accounting information to be useful to Joe (and potentially to other interested parties such as the bank).

Therefore, as part of the system of double-entry bookkeeping, a ledger account is created for each asset, liability, equity, income, and expense. There can be as many or a few ledger accounts as are necessary to manage the variety of an organisation’s transactions. The traditional structure of a ledger account for bookkeeping purposes is as follows:

DR [Account name] CR

Date Details Amount (€) Date Details Amount (€)

This is the debit side. This is the credit side.

For each account, the ledger page is split in half vertically. The left side of the account is reserved for accounting debits (referred to as the ‘debit side’) and the right side of the account is reserved for accounting credits (referred to as the ‘credit side’). Preparing ledger accounts using this structure is commonly referred to as preparing ‘T-accounts’.

Accounting software applications often structure the presentation of ledger accounts slightly differently, for example as follows:

[Account name]

Date Details Amount (€) Amount (€)

DR CR

Debit Credit

entries entries

in this in this

column. column.

This columnar approach records the same information as the T-accounts but the presentation format is slightly different.

JoeCo’s ledger accounts after 21 days of transactions (using T-account format) are as set out below. You should work carefully through each day’s transaction and trace it from the accounting journal to the appropriateledgeraccountstoconfirmyourunderstandingofhoweconomictransactionsarerecordedin ledger accounts.


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DR Bank CR


Day 1 Owner equity 10,000 Day 3 Loan 1,000

Day 2 Loan 7,500 Day 4 Purchases 2,400

Day 5 Sales 6,100 Day 15 Trade Payables 1,100

Day 14 Trade Receivables 1,900 Day 17 Trade Payables 450

Day 16 Trade Receivables 900 Day 18 Rates 650

Day 21 Computer Equipment 1,390

Day 31 Balance c/f 19,410

26,400 26,400

Day 1

(new month)Balance b/f 19,410

DR Owner Equity CR


Day 31 Balance c/f 10,000 Day 1 Bank 10,000

Day 1


DR Loan CR


Day 3 Bank 1,000 Day 2 Bank 7,500


7,500 7,500

Day 1


DR Purchases CR


Day 4 Bank 2,400

Day 8 Cash 400

Day 13 Trade Payables 2,850 Day 31 Balance c/f 5,650

5,650 5,650

Day 1



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DR Sales CR


Day 5 Bank 6,100

Day 6 Cash 830

Day 31 Balance c/f 11,430 Day 12 Trade Receivables 4,500

11,430 11,430

Day 1


DR Rent CR


Day 7 Cash 80 Day 31 Balance c/f 80

Day 1

(new month)Balance b/f 80

DR Cash CR


Day 6 Sales 830 Day 7 Rent 80

Day 11 Purchases returns 100 Day 8 Purchases 400

Day 9 Insurance 150

Day 10 Sales returns 115

Day 20 Light and heat 57

Day 31 Balance c/f 128

930 930

Day 1


DR Insurance CR



Day 1


DR Sales returns CR



Day 1



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DR Purchases returns CR


Day 31 Balance c/f 100 Day 11 Cash 100

Day 1


DR Trade Receivables CR


Day 12 Sales 4,500 Day 14 Bank 1,900

Day 16 Bank/Discount 1,000


4,500 4,500

Day 1


DR Trade Payables CR


Day 15 Bank 1,100 Day 13 Purchases 2,850

Day 17 Bank/Discount 500


2,850 2,850

Day 1


DR Discount Allowed CR


Day 16 Trade Receivables 100 Day 31 Balance c/f 100

Day 1


DR Discount Received CR


Day 31 Balance c/f 50 Day 17 Trade Payables 50

Day 1



30


DR Rates CR


Day 18 Bank 650 Day 31 Balance c/f 650

Day 1


DR Motor Vehicles CR


Day 19 Other Payables 3,750 Day 31 Balance c/f 3,750

Day 1


DR Other Payables CR


Day 31 Balance c/f 3,750 Day 19 Motor Vehicles 3,750

Day 1


DR Light and Heat CR



Day 1 (new

month)Balance b/f 57

DR Computer Equipment CR


Day 21 Bank 1,390 Day 31 Balance c/f 1,390

Day 1


Note the following:

• For each entry that is recorded in a ledger account, the ‘details’ column should include the name of the other account that is affected by the accounting journal. For example, the Day 1 transaction is debited to the bank account and the entry in the ‘Details’ column of the bank account is ‘Owner Equity’ because Owner Equity is the other ledger account that is affected by the accounting journal. Correspondingly, in the Owner Equity ledger account, the ‘Details’ column for the Day 1 transaction is ‘Bank’ because ‘Bank’ is the name of the other account affected by the accounting journal.


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• A new ledger account is created when required. The order in which JoeCo’s ledger accounts are presented is approximately the order in which they needed to be opened based on the sequence of underlying accounting journals and transactions.

• Thereisnofixedorclosedlistofpossibleledgeraccounts.Aledgeraccountcanbeopenedforanytype of asset, liability, equity, income or expense account and it is unlikely that any two organisations would have the same accounting ledgers. The detail and makeup of an accounting ledger is likely to bespecifictoeachorganisation.

2.8 BALANCING OFF LEDGER ACCOUNTSIn JoeCo’s ledger accounts above, you may have noticed the ‘Balance c/f’ and ‘Balance b/f’ entries. This is referred to as ‘balancing off’ ledger accounts - its purpose is to determine the net debit or net credit balance on each ledger account on a periodic basis. In the case of JoeCo, each ledger account is balanced off at 31 January 20X5 to determine whether there is a net debit or credit balance on each account. For example, JoeCo’s bank ledger account for January 20X5 is as follows:

DR Bank CR


Day 1 Owner equity 10,000 Day 3 Loan 1,000

Day 2 Loan 7,500 Day 4 Purchases 2,400

Day 5 Sales 6,100 Day 15 Trade Payables 1,100

Day 14 Trade Receivables 1,900 Day 17 Trade Payables 450

Day 16 Trade Receivables 900 Day 18 Rates 650

Day 21 Computer Equipment 1,390


26,400 26,400

Day 1


Many ledger accounts, such as the bank account, are likely to have numerous accounting entries. In the absence of balancing off the ledger account on a periodic basis, the net position on the bank account would not be obvious. However, when it is balanced off at the end of the month, it is possible to see that, because of all the January 20X5 transactions, the outcome at the end of the month is a net debit balance.Thissignifies that increases(debits)exceededdecreases(credits)on thebankaccount. Inother words, JoeCo has €19,410 in the bank.

In general, a ledger account is balanced off as follows (follow these steps carefully through each of JoeCo’sledgeraccountstoconfirmyourunderstanding):

Step 1 Sum both sides of the ledger account and identify the side with the lower total.

Step2 Insertabalancingfigureonthesidewiththelowertotalsuchthatbothsidesnowsumtothesametotal.Thebalancingfigureisdescribedas‘Balancec/f’(carryforward).Itisotherwiseknown as the ‘closing balance’ on the account.


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Step 3 Insert the totals on both sides of the ledger account.

Step 4 Bring the balance down to the other side of the ledger account and describe it as ‘Balance b/f’ (brought forward). The ‘Balance b/f’ is the ‘opening balance’ for the new month (February in JoeCo’s case) – it is the status of the account before any new transactions are recorded during the new month.

In some accounting material, you may see ‘Balance c/f’ replaced by ‘Balance c/d’ (carry down) and you may see ‘Balance b/f’ replaced by ‘Balance b/d’ (brought down). These slight changes in terminology are of no consequence and do not change the meaning of the balance.

You should expect to see balances on ledger account as follows for the different types of account:

Type of account Account balance

Asset Debit side

Liability Credit side

Equity Credit side

Income Credit side

Expense Debit side


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2.9 EXTRACTING A TRIAL BALANCEA ‘Trial Balance’ is a list of ledger balances that are ‘extracted’ from the ledger at a given point in time. For example, JoeCo’s ledger accounts are balanced off on 31 January 20X5 so a trial balance can be extracted at that date as follows:

JoeCoTrial Balance as at 31 January 20X5

Account Type Dr Cr

€ €

Bank Asset 19,410

Owner equity Equity 10,000

Loan Liability 6,500

Purchases Expense 5,650

Sales Income 11,430

Rent Expense 80

Cash Asset 128

Insurance Expense 150

Sales returns Expense 115

Purchases returns Income 100

Trade Receivables Asset 1,600

Trade Payables Liability 1,250

Discount Allowed Expense 100

Discount Received Income 50

Rates Expense 650

Motor Vehicles Asset 3,750

Other Payables Liability 3,750

Light and Heat Expense 57

Computer Equipment Asset 1,390

33,080 33,080


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Note the following:

• The balance on each ledger account is listed in either the debit column or the credit column of the trial balance depending on whether the balance on the ledger account is a debit balance or a credit balance.

• The total of the debit balances is equal to the total of the credit balances. This is the primary purpose of extracting the trialbalance–toconfirmthatthedouble-entrybookkeepingiscarriedoutmethodicallyand that all debit entries to the ledger accounts are matched by corresponding credit entries. That the total of the debit balances equals the total of the credit balances is proof that the accounting equation returns to equilibrium after 21 days of JoeCo transactions. If a trial balance does not balance, it indicatesthatthebookkeepinghasnotbeensufficientlymethodicalandtheaccountingequationisnot in equilibrium.

• A trial balance may balance but this does not mean that all the bookkeeping is necessarily correct. A trial balance that balances only proves that the bookkeeping is methodical. An incorrect accounting debit and a corresponding incorrect accounting credit would balance a trial balance but the information in the ledger would be incorrect. For example, the accounting entry for a credit sales transaction is to debit the trade receivables and credit the sales. However, it the bookkeeper incorrectly debited the sales and credited the trade receivables, then the trial balance would still balance but the accounts would show incorrect information.

• JoeCo’s trial balance includes a column for ‘Account Type’. This is included for educational purposes only (you would not normally see this column in a trial balance). It is included to demonstrate how the debit or credit balance for each ledger account corresponds to the type of account.


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2.10 SUMMARY OF DOUBLE-ENTRY BOOKKEEPING FOR COMMON TRANSACTIONS

Transaction Dr Cr

Introduction of cash by owner, owner invests money in the business

Cash(Increase in asset)

Owner Capital(Increase in equity)

Capital expenditure, paid for with cashAsset(Increase in asset)

Cash(Decrease in asset)

Capital expenditure on creditAsset(Increase in asset)

Other Payables(Increase in liability)

Purchase of goods for cashPurchases(Increase in expense)


Purchase of goods on creditPurchases(Increase in expense)

Trade Payables(Increase in liability)

Return of goods bought on credit from supplierTrade Payables(Decrease in liability)

Purchases Returns(Increase in income)

Sale of goods for cashCash(Increase in asset)

Sales(Increase in income)

Sale of goods on creditTrade Receivables(Increase in asset)

Sales(Increase in income)

Customer returns goods bought on creditSales returns(Increase in expense)

Trade Receivables(Decrease in asset)

Payment to a trade payable by cashTrade Payables(Decrease in liability)


Receipt from trade receivable in cashCash(Increase in asset)


Drawings by sole trader ownerDrawings(Decrease in equity)


Payment of expense in cashExpense(Increase in expense)


Cash received as a loanCash(Increase in asset)

Loan(Increase in liability)

Rental income for letting premises received in cash

Cash(Increase in asset)

Rental income(Increase in income)

Discount allowedDiscount Allowed(Increase in expense)


Discount receivedTrade Payables(Decrease in liability)

Discount Received(Increase in income)


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2.11 SUMMARY AND CONCLUSIONSIt would not be an overstatement to say that this chapter is the single most important chapter in this course manual. It sets out the foundations for most of what follows in the remaining chapters.

The accounting equation (Assets = Liabilities + Equity) is the basis of double-entry bookkeeping. Consequently, every economic transaction has a two-fold effect on the accounting equation.

The accounting equation can be expanded to incorporate different types of assets (such as bank and trade receivables), different types of liabilities (such as loan and trade payables), income (such as sales), overhead expenses (such as purchases, rent, and insurance) and equity. Income and expenses can be regarded as equity type accounts thereby enabling the accounting equation to return to equilibrium after each transaction. There are no exceptions to the requirement for the accounting equation returning to equilibrium after each transaction. Hence, effective double-entry bookkeeping requires method and discipline.

Chapter3explainshowwecanproceedfromtrialbalancetothepreparationofbasicfinancialstatementsforJoeCo(namelytheincomestatementandthestatementoffinancialposition).

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CHAPTER 3: INTRODUCTION TO PREPARATION OF FINANCIAL STATEMENTS OF A SOLE TRADER

CHAPTER 3

Introduction to Preparation of Financial Statements of

a Sole Trader

LEARNING OUTCOMES


1. Explain the main steps in an accounting system from initial recording of a transaction to preparationoffinancialstatements

2. Prepare an income statement based on income ledger account and expense ledger account balances

3. Prepareastatementoffinancialpositionbasedonasset, liability,andequity ledgeraccountbalances

4. Prepareaformattedincomestatementandaformattedstatementoffinancialpositionbasedona list of balances presented as a trial balance

REVISION RESOURCES


Chapter 3 : Introduction to Preparation of Financial Statements of a Sole Trader

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3.1 INTRODUCTION TO PREPARATION OF FINANCIAL STATEMENTSTheaccountingsystempresented todate that leads to thepreparationoffinancialstatements isasfollows:

1. Draft an accounting journal for each transaction

2. Update ledger accounts based on the accounting journals

3. Balance off ledger accounts on a periodic basis

4.Extracttrialbalancetoconfirmsumofdebitbalancesequalssumof

credit balances

5.Prepareincomestatementandstatementoffinancialposition

Chapter2introducesthefirstfourstepsofthesystem.Thischaptersetsouthowtopreparefinancialstatements based on balances that are listed in a trial balance.


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3.2 INCOME STATEMENT – DOUBLE-ENTRY BOOKKEEPINGAn income statement is a single statement that presents the income earned and expenses incurred by an organisation during a reporting period. An income statement is also a ledger account and is part of the system of double-entry bookkeeping. At reporting period end, income and expense balances are transferred from individual income ledger accounts and expense ledger accounts to the income statement ledger account. As such, all income and expenses are transferred to a single income statement ledger account.

Recall from chapter 2 that JoeCo balances off the ledger accounts and extracts a trial balance at 31 January 20X5. JoeCo’s trial balance at 31 January 20X5 is as follows:

JoeCo

Trial Balance as at 31 January 20X5

Account Type Dr Cr

€ €

Bank Asset 19,410




Sales Income 11,430

Rent Expense 80

Cash Asset 128








Rates Expense 650





33,080 33,080


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If JoeCo prepares an income statement for the month ended 31 January 20X5, then the balances on JoeCo’s ledger accounts that are ‘income’ or ‘expense’ type accounts must be transferred to the income statement by means of the following accounting journals:

Account € €

Day 31

Dr Income Statement 5,650

Cr Purchases 5,650

Dr Sales 11,430

Cr Income Statement 11,430

Dr Income Statement 80

Cr Rent 80


Cr Insurance 150


Cr Sales Returns 115

Dr Purchases Returns 100

Cr Income Statement 100


Cr Discount Allowed 100

Dr Discount Received 50

Cr Income Statement 50


Cr Rates 650


Cr Light and Heat 57


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JoeCo’s ledger accounts at 31 January 20X5 for income and expenses are updated and set out below. Note how the balances on all individual income and expense accounts are transferred to the income statement ledger account (which is the last account listed in this ledger):

DR Purchases CR


Day 4 Bank 2,400

Day 8 Cash 400

Day 13 Trade Payables 2,850 Day 31 Balance c/f 5,650

5,650 5,650

Balance b/f 5,650 Day 31 Income Statement 5,650

DR Sales CR


Day 5 Bank 6,100

Day 6 Cash 830

Day 31 Balance c/f 11,430 Day 12 Trade Receivables 4,500

11,430 11,430

Day 31 Income Statement 11,430 Balance b/f 11,430

DR Rent CR



Balance b/f 80 Day 31 Income Statement 80

DR Insurance CR




DR Sales returns CR





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DR Purchases returns CR


Day 31 Balance c/f 100 Day 11 Cash 100

Day 31 Income Statement 100 Balance b/f 100

DR Discount Allowed CR


Day 16 Trade Receivables 100 Day 31 Balance c/f 100


DR Discount Received CR


Day 31 Balance c/f 50 Day 17 Trade Payables 50

Day 31 Income Statement 50 Balance b/f 50

DR Rates CR


Day 18 Bank 650 Day 31 Balance c/f 650


DR Light and Heat CR





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DR Income Statement CR


Day 31 Purchases 5,650 Day 31 Sales 11,430

Day 31 Rent 80 Day 31 Purchases Returns 100

Day 31 Insurance 150 Day 31 Discount Received 50

Day 31 Sales Returns 115

Day 31 Discount Allowed 100

Day 31 Rates 650

Day 31 Light and Heat 57


11,580 11,580

Balance b/f 4,778

Note the following:

• All the income and expense ledger account balances are transferred to the income statement ledger account at reporting period end (31 January 20X5 in the case of JoeCo). Thus, all individual income andexpenseledgeraccountbalancesreturntozeroatthebeginningofeachnewreportingperiod.

• The closing credit balance on the income statement ledger account is €4,778. A credit balance on the income statement means that the income exceeds the expenses. In other words, JoeCo made a profitfortheperiod.Iftherewasadebitbalanceontheincomestatementledgeraccount,thiswouldmean that the expenses exceed the income, i.e., a loss was incurred by JoeCo for the reporting period.

Thefinalstepinthedouble-entrybookkeepingprocessforagivenreportingperiodistotransfertheprofitorlossfortheperiodtoownerequity.Itistheownersofabusinesswhoenjoytheprofitorsufferthelossforthereportingperiodso,ultimately,aprofitorlossoutcomeshouldbereflectedinthe‘Owner Equity’ ledger account. In the case of JoeCo, the accounting journal to effect the transfer is as follows:

Account € €

Day 31

Dr Income Statement 4,778

Cr Owner Equity 4,778


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JoeCo’s ‘Owner Equity’ and ‘Income Statement’ ledger accounts are affected as follows:

DR Owner Equity CR


Day 31 Balance c/f 10,000 Day 1 Bank 10,000

Day 31 Balance b/f 10,000

Day 31 Balance c/f 14,778 Day 31 Income Statement 4,778

14,778 14,778

Balance b/f 14,778

DR Income Statement CR


Day 31 Purchases 5,650 Day 31 Sales 11,430

Day 31 Rent 80 Day 31 Purchases Returns 100

Day 31 Insurance 150 Day 31 Discount Received 50

Day 31 Sales Returns 115

Day 31 Discount Allowed 100

Day 31 Rates 650

Day 31 Light and Heat 57


11,580 11,580

Day 31 Owner Equity 4,778 Day 31 Balance b/f 4,778

Note the following:

• The ‘Income Statement’ ledger balance is transferred to ‘Owner Equity’ which means that the ‘Income Statement’balancereturnstozeroforthebeginningofthenewreportingperiod.

• The ‘Owner Equity’ balance represents the amount of the owner’s stake in the business. The closing balancecomprises the€10,000 thatowner, Joe,originally investedplus the€4,778profit for themonth of January 20X5.


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3.3 STATEMENT OF FINANCIAL POSITION – A LIST OF BALANCESHaving closed out the income and expense balances to the income statement and then closed out the income statement to owner equity, JoeCo’s trial balance (revised) is now as follows:

JoeCo


Account Type Dr Cr

€ €

Bank Asset 19,410



Cash Asset 128






26,278 26,278

Note the following:

• Only assets, liabilities and equity type accounts are listed in this trial balance.

• Theneteffectofallincomeandexpensesisnowreflectedinthe‘OwnerEquity’balance.


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We can present this list of balances as a ‘Statement of Financial Position’ as follows:

JoeCo

Statement of Financial Position as at 31 January 20X5

€ €Assets

Bank 19,410

Cash 128

Trade Receivables 1,600

Motor Vehicles 3,750

Computer Equipment 1,390

Total assets 26,278

Equity

Owner Equity 14,778

Liabilities

Loan 6,500

Trade Payables 1,250

Other Payables 3,750

11500

Total Equity and Liabilities 26,278

Note the following:

• Astatementoffinancialpositionisalistofassets,liabilities,andequityatapointintime(31January20X5 in the case of JoeCo).

• Recall from chapter 2 that it is important to distinguish between capital expenditure and revenue expenditure. It should now be evident why that distinction is important – whereas JoeCo’s revenue expenditure accounts are closed out to the income statement at reporting period end, the capital expenditure accounts (the motor vehicles and the computer equipment) remain listed as assets on thestatementoffinancialposition.Inotherwords,theaccountingoutcomeforcapitalexpenditureinfinancialstatementsiscompletelydifferenttotheaccountingoutcomeforrevenueexpenditure.

• The total of the assets equals the sum of the equity and liabilities.Thus,everystatementoffinancialposition is an expression of the accounting equation. In effect, the accounting process has come full circle since Day 1 to return on Day 31 to an expression of the accounting equation. It is important to appreciate that methodical double-entry bookkeeping throughout the process ensures that the accounting equation remains in equilibrium throughout. Any deviation from methodical double-entry bookkeepingrisksanimbalancein(1)thetrialbalanceand(2)thestatementoffinancialposition.


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3.4 FORMATTED FINANCIAL STATEMENTS

Many readers of financial statements are not experts in double-entry bookkeeping nor are theynecessarily experts in accounting. It is likely to be of little use, therefore, to present an income statement intheformatofaledgeraccount.Iftheobjectiveoffinancialaccountingistoprovideusefulinformationtoawidevarietyofinterestedparties,thenfinancialstatementsalsoneedtobepresentedinaformatthat is useful.

3.4.1 Formatted Income Statement

In practice, the income statement of a sole trader would commonly look as follows:

[Name of reporting entity]

Income Statement for the year ended 31 December 20XX

€ € €Sales X Less Sales Returns (X) Net Sales X Less Cost of Sales Opening inventories (Chapter 4) X Purchases X Less Purchases Returns (X) X Carriage inwards X Cost of goods available for resale X Less closing inventories (Chapter 4) (X) Cost of sales (X)Gross Profit X Discount received X Less Expenses Carriage outwards X Discount allowed X Rent and rates X Wages and Salaries (Chapter 8) X Irrecoverable debts (Chapter 5) X Insurance X Depreciation (Chapter 7) X Other expenses (i.e., this list of expenses is not exhaustive) X Total expenses (X)

Net profit or (loss) for the year X


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Note the following:

• The formatted income statement contains the same information that is included in an income statement ledger account. The accounting logic is the same, it is just the presentation format that differs.

• The accounting for some of the items of income and expenditure presented in this income statement is addressed in later chapters but they are included here to provide a representative example of an income statement.

• Thetoppartoftheincomestatement(downtothe‘GrossProfit’line)iscommonlyreferredtoasthe‘trading account’. Grossprofitisacalculationoftheprofit(orloss)thatarisespurelyfromactivitiesdirectly relating to the trade of the business. For example, recall from chapter 2 that JoeCo’s business issellingrecyclableplasticbottles.JoeCo’sgrossprofitisthereforecalculatedbyreferencetobuyingand selling of recyclable plastic bottles before taking into consideration any of the overhead expenses incurred in running the business.

• ‘Cost of Sales’ (otherwise known as ‘cost of goods sold’) is the cost of goods that are sold during the year (as opposed to cost of goods bought during the year). The calculation of cost of sales is an importantcomponentofthecalculationofgrossprofit.

• Carriage inwards is included as part of the calculation of cost of sales but carriage outwards is classifiedasanoverheadexpense.The reason for includingcarriage inwards incostofsales isbecause it is an expense associated with bringing goods to the point of being available for sale. Any expenses incurred after the point of goods being available for sale are included as selling costs, which are accounted for as overheads. Carriage outwards is an overhead because it is an expense incurred as part of the completion of a sale (i.e., after the goods have reached the point of being ready for sale).

• Overheadsarededucted from thegrossprofit tocalculateanetprofitor loss for theyear. If theincomestatementispreparedforareportingperiodofayear,thennetprofitiscalculatedbasedontwelve months of income minus twelve months of expenses.

Thedeductionofcostofsalesfromsalestocalculategrossprofitandthedeductionoftwelvemonthsof overhead expenses from twelve months of sales are two examples of the ‘matching’ concept in accounting. The matching concept is related to the accrualsconcept(brieflyintroducedinchapter2).The accruals concept states that income should be recorded in the accounting records when it is earned and expenses should be recorded when they are incurred. The matching concept is related to the accruals concept in that income earned during a reporting period should be matched with the expenses incurred to earn that income.

For example, if JoeCo sold 10,000 recyclable plastic bottles during a reporting period, then the cost of sales for the same reporting period should be the cost of selling those 10,000 plastic bottles (even if JoeCo purchased, say, 12,000 plastic bottles during that reporting period). The accruals and matching concepts work in tandem to recognise that if JoeCo sold 10,000 bottles and purchased 12,000 bottles duringthereportingperiod,thegrossprofitcalculationwouldbebasedonthesellingandcostofselling10,000 bottles (matching concept). The expense associated with the purchase of the other 2,000 bottles wouldberecorded(accrualsconcept)butwouldbeclassifiedas‘closinginventories’thatareavailablefor sale in the next reporting period. Chapter 4 addresses this topic in greater detail.

Another example of the matching concept is the matching of twelve months of income earned with twelve months of overhead expenses incurred (such as insurance or rent) even if some amount other than twelve months of the overhead expenses were paid. For example, if JoeCo earned twelve months


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of income but only paid nine months of rent during the twelve-month period, then an accounting adjustment would be required to record twelve months of the rent expense incurred (accruals). The netprofitcalculationwouldbebasedonmatchingincomeearnedwithexpensesincurred.Chapter6addresses this topic in greater detail.

3.4.2 Formatted Statement of Financial Position

A formattedstatementoffinancialpositionforasoletraderwouldcommonlylookasfollows:

[Name of reporting entity]Statement of Financial Position as at 31 December 20X5

€ € €

Non-Current Assets (Chapter 7) CostAccumulated Depreciation

Net Book Value (NBV)

Land and Buildings X X XPlant and Machinery X X XMotor Vehicles X X X X X XCurrent Assets Inventories (Chapter 4) X Trade Receivables X Prepayments (Chapter 6) X Bank X XTotal Assets X Equity and Liabilities Equity Capital Owner Equity at the beginning of the period X plus new owner capital invested X plus/(minus)netprofit/(loss)fortheyear(fromIncomeStatement) X minus drawings (X) Owner Equity at the end of the period X Non-Current Liabilities Bank Loan X Current Liabilities Trade Payables X Bank overdraft X Accruals (Chapter 6) X XTotal Equity and Liabilities X


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Note the following:

• Assetsareclassifiedaseither‘non-current’or‘current’.Current assets are those that are likely to be converted into cash in the short-term future (usually within a year) and are commonly related to the trade of the business (examples include inventories and trade receivables). Non-current assets are those that are used within the business (they are not bought with the intention of being sold) and are likelytogenerateeconomicbenefitsforthebusinessformorethanoneyear.

• Liabilitiesaresimilarlyclassifiedaseither‘non-currentor‘current’.Current liabilities are those that have to be settled within the short-term future (usually within a year) and commonly relate to the trade of the business (examples include trade payables and bank overdrafts). Non-current liabilities are those that are likely to be settled after one year.

• The equity section commonly shows the changes in owner capital from the beginning to the end of the reporting period (and presents information which is the equivalent of the ‘Owner Equity’ ledger account).

• The term ‘drawings’ refers to withdrawals of capital from the business by the owners. The withdrawals may be in the form of money or goods. The relevant accounting journals are as follows when there are withdrawals of money or goods from the business by the owner:

€ Dr

€ Cr

Dr Drawings X

Cr Bank or Cash X

€ Dr

€ Cr

Dr Drawings X

Cr Purchases X

By convention, a ‘Drawings’ ledger account is used to record withdrawals of capital from the business by the owner (as opposed to debiting the ‘Owner Equity’ account).

• Notwithstandingclassificationsofassetsandliabilitiesas‘non-current’and‘current,andthedetailofinformationintheequitysection,overall,thestatementoffinancialpositionisstillanexpressionofthe accounting equation (assets = liabilities + equity).

• There is more than one way in which the accounting equation can be expressed. Examples include the following:• Assets – Liabilities = Owner Equity• Assets–Liabilities=OpeningEquity+Capitalintroduced+Profit–Drawings

• Remember the importance of identifying expenditure accurately as either revenue or capital expenditure. The consequences of mis-classifying revenue expenditure incorrectly as capital expenditure or mis-classifying capital expenditure as revenue expenditure are significant. Mis-classificationof expendituremeans that the calculationsof bothnet profit and total assets (bothimportantnumbersinfinancialstatements)wouldlikelybewrong.


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3.4.3 Formatted Financial Statements for JoeCo

JoeCo’s trial balance at 31 January 20X5 is as follows:

JoeCoTrial Balance as at 31 January 20X5

Account Type Dr Cr € €Bank Asset 19,410




Sales Income 11,430

Rent Expense 80

Cash Asset 128








Rates Expense 650





33,080 33,080

Aformattedincomestatementandstatementoffinancialpositioncanbeprepareddirectlyfromatrialbalance (on the understanding that the double-entry bookkeeping presented earlier in this chapter underpinsthepreparationofthosefinancialstatements).


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JoeCo’sformattedfinancialstatementsareasfollows:

JoeCo

Income Statement for the month ended 31 January 20X5 € €Sales 11,430

Sales returns (115)

11,315

Less Cost of Sales

Opening Inventories 0

Purchases 5,650

Less Purchases Returns (100)

5,550

Closing Inventories 0

(5,550)

Gross Profit 5,765 Discount Received 50

5,815

Less Expenses

Rent 80

Insurance 150

Discount Allowed 100

Rates 650

Light and Heat 57

(1,037)

Net profit for the month 4,778


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JoeCo

Statement of Financial Position as at 31 January 20X5 € €Non-Current Assets



5,140

Current Assets


Bank 19,410

Cash 128

21,138

Total assets 26,278

Equity

Owner Equity at the beginning of the month 10,000

Profitforthemonth 4,778

14,778

Non-Current Liabilities

Loan 6,500

Current Liabilities



5,000


Formattedfinancialstatementsaddvaluetotheaccountingprocess.Informationispresentedinwaysthataremoreeasilyunderstoodbynon-accountingreadersofthefinancialstatements.Itisalsopossibletodistinguishbetweengrossprofitandnetprofit,betweennon-currentassetsandcurrentassets,andbetween non-current liabilities and current liabilities.


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3.5 SUMMARY AND CONCLUSIONSAtthebeginningofthischapter,afivestepfinancialaccountingsystemissetout.

Whereasfinancialstatementsarecommonlypresentedasformattedreports,itisimportanttoappreciatethatfinancialstatementsareunderpinnedbythedouble-entrybookkeepingsystem.Thisisevidentfromeverystatementoffinancialposition,eachinstanceofwhichisanexpressionoftheaccountingequation.

We have demonstrated the double-entry bookkeeping logic and method that underpin the preparation of anincomestatementandstatementoffinancialposition.However,itmustbeacknowledgedthatmostaccounting software applications hide much of the double-entry bookkeeping logic that is associated withthepreparationoffinancialstatements.Moreover,allgoodaccountingsoftwareapplicationswouldincludecontrolstopreventauserfromgeneratingatrialbalanceorastatementoffinancialpositionthatdoes not balance. But this is not to suggest that a solid understanding of double-entry bookkeeping is no longer of value. On the contrary, it is crucial that accountancy professionals have the competencies and skills necessary to use accounting software knowledgeably and to assess the quality of information that is produced by accounting software applications.

Chapter 4 introduces the principles and practice of accounting for inventories.

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CHAPTER 4: INVENTORIES

CHAPTER 4

Inventories

LEARNING OUTCOMES


1. Calculate the value of inventories

2. Account for closing inventories

3. Account for opening inventories

4. Preparefinancialstatementsforasoletraderwithadjustmentforclosinginventories

REVISION RESOURCES


Chapter 4 : Inventories

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4.1 THE NATURE OF INVENTORIESAt any given point in time during a reporting period, inventories consist of goods purchased from suppliers that are available for sale to customers. It is normal for many businesses to have stocks of inventories on hand that are available for sale (hence the reason that inventories are also commonly referred to as ‘stock’).Thinkofanyretailbusiness(Amazonforexample)anditispossibletovisualisetheinventoriesthat a business constantly manages.

In the case of a manufacturing business, inventories consist of:

• Goods purchased for resale

• Raw materials to be used in production (not yet processed)

• Partlyfinishedgoods(otherwiseknownasworkinprogress(WIP)

• Finished goods (and ready for sale)

For example, a furniture manufacturing business is likely to have, at any given point in time, inventories thatcomprise,rawmaterials,workinprogressandfinishedgoods.

4.2 VALUATION OF INVENTORIESAttheendofeachfinancialyear,abusinessmustaccountspecificallyforgoodsthathavebeenboughtbut not sold – these goods are referred to as the closing inventories of the business.

Formanybusinesses,theclosinginventoriesfigureisimportantbecauseitdirectlyimpactsonthegrossprofitreportedintheincomestatementandthecurrentassetsonthestatementoffinancialposition.Inmanybusinesses(suchasretailers),closinginventoriescanformasignificantpartofcurrentandtotalassets.

At the end of each reporting period, a business must establish the quantity of each item of inventory that is on hand. This is commonly achieved by undertaking a physical inventory count (otherwise known as a ‘stocktake’). In some organisations, computerised accounting records can generate reports that list the inventory quantities that should be on hand (commonly known as ‘book stock’) but having a book stock does not eliminate the need for a periodic physical count of all inventories.

4.2.1 Cost

Once the stocktake is complete, the quantities of each inventory itemmust be valued. In the firstinstance,thecostofeachitemisidentified.Thisislikelytobedonebyreferenceprimarilytorecordsofsupplier invoices.

However, ‘cost’ in the context of inventories has a particular meaning. In general, the ‘cost’ of inventories includes all expenditure incurred in bringing the product or service to its present location and condition for the purpose of getting it ready for sale. This includes the following:

• Cost of purchase – purchase price, import duties and any other taxes, transport, handling, and any other directly attributable costs. Trade discounts and rebates are deducted.


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• Cost of conversion (for manufacturing businesses) – this includes direct costs, such as direct material, direct labour, direct expense, and production overheads. Examples of relevant costs include factory rent and rates, factory light and heat.

The outcome of this process is the calculation of the cost of each item of inventory on hand. At this point, it is necessary to compare the cost of each item with its corresponding ‘selling price less costs to complete and sell’.

4.2.2 Selling Price less Costs to Complete and Sell

‘Selling price less costs to complete and sell’ is otherwise commonly known as ‘net realisable value’. Net realisable value (NRV) is the gross revenue expected to be generated in the future when the goods are sold, less any further costs (including selling costs) that need to be incurred to complete the sale, i.e., the selling price, less trade discounts, all further costs to completion and all marketing, selling and distribution costs.

Net realisable value is calculated as follows:

€ €

Selling price X

Deduct:

Trade discounts X

All further costs to completion X

All marketing, selling and distribution costs X

(X)

Net realisable value X

The purpose of the comparison of the cost of an item of inventory with its net realisable value (NRV) is to answer the question as to whether there is evidence that a business is likely to sell the item for less than it cost. In other words, is the net realisable value less than the cost? It is necessary to address this question because:

Inventories must be measured at the lower of (1) cost and (2) estimated selling price less costs to complete and sell. This is often referred to as the ‘lower of cost and net realisable value’. You should be aware of the different ways in which this principle for measuring inventories can be expressed.

When calculating the NRV of an item of inventory for comparison with its cost, calculations must be done on an item by item basis. It is possible therefore that some items of inventory will be valued at ‘cost’ and others at ‘net realisable value’. However, for businesses with large volumes of similar items of inventory, it is acceptable to group similar items together and to undertake cost/NRV comparisons based on groups of inventory items.


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Example 1

What is the correct valuation of each of items 1, 2 and 3 and in total in the following table?

Item CostCost to

completeSelling costs Selling price Valuation

€ € € € €

1 1,000 nil 50 1,500 ?

2 2,000 500 100 2,400 ?

3 3,000 800 200 3,800 ?

Solution to Example 1

Step 1 – calculate the net realisable value of each item

Item 1 Item 2 Item 3

€ € €

Selling price 1,500 2,400 3,800

Deduct:

Cost to complete 0 (500) (800)

Selling costs (50) (100) (200)

Net realisable value 1,450 1,800 2,800

Step 2 – compare the cost and net realisable value of each item

Item Cost NRV Valuation

€ € €

1 1,000 1,450 1,000

2 2,000 1,800 1,800

3 3,000 2,800 2,800

Total value of inventories 5,600


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Example 2

Tara’s business sells three products, A, B and C. Upon completion of a stocktake, the following information was available at year end in relation to closing inventories:

A B C

€ € €

Cost 7 10 19

NRV 10 8 15

Units 100 200 300

What is the total value of Tara’s closing inventories at year end?

Solution to Example 2

A Cost is lower => €7 x 100 units = €700

B NRV is lower => €8 x 200 units = €1,600

C NRV is lower => €15 x 300 units = €4,500

Total value of inventories €6,800

4.3 ACCOUNTING FOR INVENTORIES

4.3.1 Closing Inventories

Once the valuation of inventories is complete, the accounting journal to record inventories in the ledger is drafted. The standard accounting journal to record inventories at the end of a reporting period (closing inventories) is as follows:

€ €

Dr Inventories (increase in asset) (SFP) X

Cr Cost of sales (decrease in expense) (Inc. St.) X


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Example 3

To understand the logic of the accounting journal that records closing inventories, consider the following ledger accounts in which transactions have been recorded during Year 1 of the existence of a business (including closing inventories that have been valued at €100). Note that all entries to these ledger accounts are underpinned by accounting journals.

Dr Sales Cr

€ €

Income statement 620 Trade receivables 500

Bank 120

620 620

The accounting entries to the sales ledger account tell us that cash and credit sales were made during the reporting period. At the end of the reporting period, the balance on the sales ledger account was transferred (by means of an accounting journal) to the income statement.

Dr Purchases Cr

€ €

Trade payables 250 Cost of sales 380

Bank 130

380 380

The accounting entries to the purchases ledger account tell us that cash and credit purchases were made during the reporting period. At the end of the reporting period, the balance on the purchases ledger account was transferred to the cost of salesledgeraccount(inthefirstinstance).

Dr Cost of sales Cr

€ €

Purchases 380 Inventories (closing) 100

Income statement 280

380 380

There are closing inventories on hand at the end of the reporting period, i.e., whereas there were purchases made during the reporting period, not all those goods purchased were sold during the same reporting period. This means that those inventories are available for sale in the next reporting period and, therefore, we should record those closing inventories as an asset (which is the debit entry in the accounting journal and shaded in the inventories ledger account below). In other words, money has beenspentongoodsduringthecurrentreportingperiod,butthebenefitofthatexpenditurewillonlyberealised in the next reporting period when those goods are sold.


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The credit entry to cost of sales ledger account above is recognition that not all goods purchased were sold. It is therefore the adjustment to change the ‘cost of purchases’ (€380 in the example) to ‘cost of sales’ (€280 in the example).

Thecostofsalesistransferredtotheincomestatementforcomparisonwiththesalesfiguretocalculatethegrossprofit.

Dr Income statement Cr

€ €

Cost of sales 280 Sales 620

Grossprofit 340

620 620

Notehowtheincomestatementcalculatesgrossprofitasthedifferencebetween(1)sales,and(2)costof sales.

Dr Inventories Cr

€ €

Cost of sales 100

The debit entry to the inventories ledger account is the closing inventories balance that is presented as acurrentassetonthestatementoffinancialposition.

The accounting journal to record the closing inventories in this example is as follows:

Dr€

Dr€

Dr Inventories (increase in assets) (SFP) 100

Cr Cost of sales (decrease in expenses) (Inc. St.) 100

Being closing inventories at the end of Year 1.

Note the inclusion of a short description in the accounting journal. This short description is commonly referredtoastheaccountingjournal‘narrative’.Itspurposeistoexplain(briefly)theeffectofthedebitand credit accounting entries. All accounting journals should include narratives as a matter of good accounting practice.

Alsonotetheinclusionintheaccountingjournalofthe‘SFP’(statementoffinancialposition)and‘Inc.St. (income statement) references. Although these references are not obligatory parts of an accounting journal,theycanbeahelpfulreminderofwhichfinancialstatementisaffectedbyanaccountingjournalentry.


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4.3.2 Opening inventories

The closing inventories at the end of a reporting period automatically become the opening inventories for the next reporting period. In Example 3, closing inventories valued at €100 were recorded in the Year 1financialstatements.Therefore,theopening inventories for Year 2 of that business will automatically be €100.

The standard accounting journal to record these opening inventories at the beginning of Year 2 is as follows:

Dr€

Dr€

Dr Cost of sales (increase in expenses) (Inc. St.) 100

Cr Inventories (decrease in assets) (SFP) 100

Being opening inventories at the beginning of Year 2.

In effect, the accounting journal to record opening inventories recognises that the inventories on hand at the end of Year 1 are available for sale again at the beginning of Year 2 and are therefore included in cost of sales for Year 2.

Example 4Assume that Example 3 above continues into Year 2 and that, in Year 2, purchases amount to €400 and closing inventories are valued at €300. The cost of sales and the inventories ledger accounts are therefore as follows:

Dr Cost of sales Cr€ €

Year 2 Inventories (opening) 100 Year 2 Inventories (closing) 300Year 2 Purchases 400 Income statement 200

500 500

Dr Inventories Cr€ €

Balance b/f (from year 1) 100 Year 2 Cost of sales 100Year 2 Cost of sales 300

Note the following:• Thelightshadingintheledgeraccountsabovereflectstheaccountingjournalthatrecordsopening

inventories for Year 2 (debit to cost of sales and credit to inventories.• Thedarkshadingintheledgeraccountsabovereflectstheaccountingjournalthatrecordsclosing

inventories for Year 2 (debit to inventories and credit to cost of sales).• Thus, at the end of each year, there is an accounting journal to record closing inventories and, at

the beginning of the following year, there is a corresponding accounting journal to record opening inventories.

• The cost of sales for inclusion in the income statement amounts to €200 for Year 2 and the closing inventoriesforinclusionasacurrentassetonthestatementoffinancialpositionisvaluedat€300(which is the balance on the inventories ledger account).


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• Thecostofsales ledgeraccountentries reflect the formula forcalculatingcostofsales:openinginventories plus purchases (both are debit entries) minus closing inventories (a credit entry).

4.4 EFFECT OF CLOSING INVENTORIES ON FINANCIAL STATEMENTSRecall that JoeCo’s trial balance at 31 January 20X5 is as follows:

JoeCo


Account Type Dr Cr

€ €

Bank Asset 19,410




Sales Income 11,430

Rent Expense 80

Cash Asset 128








Rates Expense 650





33,080 33,080

Let us now add that, after the extraction of JoeCo’s trial balance, a stocktake of the recyclable plastic bottles on hand is undertaken. A total of 1,000 bottles are counted and, with reference to ‘lower of cost and NRV’, the closing inventories are valued at €1,500.


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Note that the balance for JoeCo’s closing inventories is not included in the trial balance. Therefore, a post-trial balance accounting journal is required to record the closing inventories for inclusion in JoeCo’s financial statements. Post-trial balance accounting journals are commonly referred to as post-trialbalance ‘adjustments’.

JoeCo drafts the following accounting journal to record closing inventories:

Dr€

Dr€

Dr Inventories (increase in assets) (SFP) 1,500

Cr Cost of sales (decrease in expenses) (Inc. St.) 1,500

Being closing inventories at the end of January 20X5.

Consequently,JoeCo’sformattedfinancialstatementsareasfollows:

JoeCo

Income Statement for the month ended 31 January 20X5

€ €

Sales 11,430

Sales returns (115)

11,315

Less Cost of Sales:

Opening Inventories 0

Purchases 5,650

Less Purchases Returns (100)

5,550

Less Closing Inventories (1,500)

(4,050)

Gross Profit 7,265

Discount Received 50

7,315

Less Expenses:

Rent 80

Insurance 150

Discount Allowed 100

Rates 650

Light and Heat 57

(1,037)

Net profit for the month 6,278


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JoeCo

Statement of Financial Position as at 31 January 20X5

€ €

Non-Current Assets



5,140

Current Assets

Inventories 1,500


Bank 19,410

Cash 128

22,638

Total assets 27,778

Equity

Owner Equity at the beginning of the month 10,000

Profitforthemonth 6,278

16,278

Non-Current Liabilities

Loan 6,500

Current Liabilities



5,000


Note the following:

• An amount of €1,500 is included for closing inventories in the cost of sales. The affects the amounts ofcostofsales,grossprofit,andnetprofitforthemonth.Italsoaffectstheclosingownerequityandtotalequityonthestatementoffinancialpositionbecauseprofitbecomespartofownerequity.

• An amount of €1,500 is also included for closing inventories in the current assets on the statement of financialposition.Thisaffectsthetotalsforcurrentassetsandtotalassets.


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4.5 SUMMARY AND CONCLUSIONSThe topic of inventories is relevant to any organisation that buys and sells goods.

The process of valuing closing inventories involves a stocktake whereby items are counted, a costing of the quantities counted, and an assessment of whether the net realisable value is lower than the cost. Oncethevaluationofclosinginventoriesisfinalised,itisaccountedforbymeansofastandardjournalthat debits the inventories asset and credits cost of sales. At the beginning of the following reporting period, opening inventories is accounted for by means of a debit to cost of sales and a credit to the inventories asset.

Whenpreparingfinancial statements,post-trial balanceadjustments for closing inventoriesareverycommon. It is important to know how to record the accounting journal for closing inventories and to understanditseffectonfinancialstatements.

Chapter 5 introduces the topic of irrecoverable debts.

132672 FINANCIAL ACCOUNTING MANUAL 2021 V5

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